You’re not alone if you’ve ever applied for a personal loan and been given a rate that was seemingly random. Two people – with similar incomes – can apply for the same loan and receive offers that differ a few points, just a few. This disparity is not a random one, but rather a number of factors that lenders consider, some of which you can have some influence on, and others you can’t.
It is more beneficial to know what factors are included in the rate you are offered rather than what number you saw in an ad somewhere and know what you can do to get the better end of the stick.
Why “Average” Rates Don’t Tell You Much
The term “average personal loan rates” is commonly used in headline news, and while it doesn’t mean nothing, it can be misleading if you read it straight. An average is a mixture of borrowers with excellent credit and borrowers with poor credit, of short-term and long-term loans, and of secured and unsecured loans. That average rate may be a wide shot above or below what you will qualify for, depending on your situation.
It is better to consider personal loan interest rates as a range, and then determine where you will be likely to fall in the range based on the following factors:
Your Credit Score Does Most of the Heavy Lifting
In most cases, this is the one biggest factor. Your credit score is a fast indicator of the riskiness of you as a borrower and a large difference between a good score and an excellent score can translate into a significantly better interest rate.
Rates may be higher because the lender may view you as a risk if your score is low, but it doesn’t always mean you won’t qualify for a loan. Even if you have months in advance to pay off the loan, you can make a significant difference in the offers you receive by consistently paying on time and keeping your credit card balances manageable.
Your existing debt and income are of almost equal importance
Lenders also take into consideration your debt-to-income ratio, or how much of your monthly income is already being allocated toward paying your debts. Even if you have a good credit score, lenders could consider you more risky if a significant portion of your funds is already allocated to other loans or credit cards.
This is why it’s better to pay off debt before applying for a loan, even if it could potentially raise your score—it will definitely raise this ratio, which is also considered by lenders.
The length of the loan term affects the math
Beware of the lower interest rates that come with shorter loan terms, but higher monthly payments, because of the rapid repayment. The longer the term, the higher the rate, the lower the monthly payment – the longer the lender is exposed to the risk, the higher the interest rate.
While it’s easy to consider just the monthly payment, it’s also important to consider the overall cost of the loan when considering the total. Bigger interest payments over the life of the loan don’t always result in lower monthly payments, even if the rate appears to be the same.
Secured vs Unsecured Loans
Personal loans are typically unsecured, which means that they come without securing any collateral. Some lenders may provide secured personal loans with a savings account or car as security for a reduced interest rate.
This makes sense when you have an asset you’re okay with putting at risk and the rate difference is substantial, but you should be aware of the tradeoff: If you can’t make the payment, the asset is in jeopardy that it wouldn’t be with an unsecured loan.
Why Shopping Around Actually Works Here
One of the most overlooked tactics for personal loan applications is just to compare offers from multiple lenders before signing. Each lender considers them in slightly different ways, so you can actually receive vastly different offers when you apply to different lenders.
You can usually obtain an estimate of the rate from many lenders with a soft credit check, which is not as hard on your credit as a hard check. With this as an excuse, it’s easy to shop around a little before making a formal application and saving a significant amount over the term of the loan.
Red Flags Worth Watching For
If an offer appears to be a great deal better than any other offer you’ve seen, you should study the fine print closely. Some lenders offer low rates, but only apply to a fraction of customers, while most people are eligible for higher rates. Some may include extra fees, such as origination fees, prepayment penalties, and/or add-on insurance products, which can inflate the actual interest rate of the loan much higher than advertised.
But the most important figure isn’t the advertised rate; it’s the APR, which is intended to show the overall cost of borrowing, taking into account most fees. When comparing offers, it’s important to look at the APRs, not just the interest rates, because the interest rate is just one of the costs of credit.Interest rate is only one of the costs of credit and comparisons should be made across offers, not just interest rates.
The Bottom Line
There is no fixed formula for determining the rate you will receive on a personal loan, but neither is it a secret. Your credit score, existing debt load, the term of the loan you select, and even if you do shopping around actually does make a difference on what you’re offered. One of the best methods to secure a superior rate than you’d probably have otherwise is to put in the time to enhance your credit profile in a couple of months prior to your application, after which you can shop around for a couple of lenders.
Disclaimer:
This article is intended for general informational purposes only, and is not a financial advice. If you need advice tailored to you, seek the advice of a licensed financial adviser.
