When you apply for a personal loan, your interest rate is the most important factor that determines your loan costs. The higher your rate, the more you’ll pay for your loan, both on your monthly payments and over the course of your loan term.
When shopping for a loan, it’s important to seek out the best rates possible. Knowing the factors that commonly affect personal loan rates can help you prepare ahead of time and provide some context when you’re getting rate quotes for your loan.
Key Factors That Determine Personal Loan Rates
You may wonder why personal loan rates vary so much from one person and one lender and one person to the next. There are six factors that may impact your rates.
Credit Score
Your credit score is one of the most important factors lenders consider when setting personal loan rates. Your credit score is considered one of the best indicators of your risk. The better your credit score, the more responsibly you’ve used money in the past, and the more likely you are to make your loan payments on time (in the eyes of the lender).
Generally speaking, a higher credit score will help you land a lower interest rate, while a low credit score will result in a higher interest rate. Credit scores usually fall into several tiers — excellent, good, fair, and poor — which are used to set interest rates for borrowers within them.
Credit Scores and Interest Rates
Loan Amount
The amount you borrow on your personal loan can affect your interest rate. In many cases, lenders charge higher interest rates on larger loan amounts. After all, because you’re borrowing more money, there’s more risk to the lender if you don’t pay it back.
On the other hand, lenders may offer lower rates on higher loan amounts for well-qualified borrowers (generally those with good or excellent credit). Because these borrowers present less risk to the lender, the higher loan amount can mean more interest income for the lender.
Loan Term
Your loan term, the number of months or years you pay off your loan, can also affect your interest rates. In most cases, lenders charge lower interest rates on shorter loan terms. While longer loan terms tend to come with higher interest rates, they also have lower monthly payments because you’re spreading your repayment out over a longer period.
Opting for a longer loan term can help make your payments more affordable. However, make sure to run the numbers to see how much more interest you’ll be paying in the long run.
Table: Loan Term vs. Interest Rate (nothing to do here, just a placeholder)
Debt-to-Income Ratio (DTI)
Your debt-to-income ratio is another factor lenders can use to assess your risk. Your DTI shows the percentage of your income that goes toward debt repayment. For example, if you have a gross monthly income of $5,000 and pay $1,000 per month toward debt, you have a DTI of 20%.
The lower your DTI, the more room you have in your budget for loan payments, and the less likely you may be to miss a payment. On the other hand, someone with a higher DTI has a tighter budget, and a financial setback elsewhere could result in missed personal loan payments.
Lenders typically prefer DTIs below 36%. The lower your DTI, the lower your interest rate, while the higher your DTI, the higher your interest rate.
Formula for DTI:
DTI=(Total Monthly Debt Payments÷Gross Monthly Income)×100
Components:
Total Monthly Debt Payments:
Includes all recurring debt obligations, such as:
- Mortgage or rent payments
- Auto loan payments
- Credit card minimum payments
- Student loans
- Personal loans
- Any other debt payments
Gross Monthly Income:
- The total income earned before taxes and deductions.
- Sources might include salary, bonuses, dividends, or other regular income streams.
Example:
If your total monthly debt payments are $2,000 and your gross monthly income is $5,000
DTI=($2,000÷$5,000)×100=40%
Employment History and Income
When reviewing your loan application, lenders look for signs indicating whether you’ll likely repay what you borrowed. A steady employment history and stable income are likely to assure lenders that you can make your loan payments. As a result, you may be offered a lower interest rate.
On the other hand, you may end up with a higher rate if you have a short employment history or an unstable income (perhaps you’re self-employed or a tipped worker).
Lender-Specific Criteria
While there are some universal factors lenders use when setting interest rates, each one also uses its own formulas. That’s why you may see rates vary so much from one lender to the next. Overall, lenders look at the overall market conditions when setting interest rates. As market interest rates rise, lenders are likely to raise their loan rates, and vice versa.
Additionally, just like with borrowers, each lender has a different appetite for risk. Particularly risk-averse lenders may be likely to charge higher rates, while those with higher risk tolerances may charge lower rates.
Finally, you may happen to catch a lender when it’s offering special offers or promotions on its personal loans, which can help you land lower rates.
How Loan Purpose Affects Interest Rates
While this isn’t always the case, some lenders may consider the reason for your loan when setting your interest rates. Certain loan purposes could lower rates, while seemingly riskier purposes could result in higher rates.
For example, loan purposes like debt consolidation and home improvements may be seen by your lender as being low risk. After all, if you’re consolidating debt, you’re trying to turn your financial situation around, and at the same time, you’re eliminating other monthly payments that are eating up part of your budget. Home improvements may also be seen as low risk, especially if you’re offering up your home as collateral.
On the other hand, some purposes may be considered riskier. For example, if you’re using your personal loan for discretionary spending or to start a business, there may be a greater risk of you not being able to repay the loan. Using a personal loan for discretionary spending may be seen as irresponsible. In the case of using a loan to start a business, lenders may worry that if your business fails, you’ll default on the loan.
Types of Interest Rates
When shopping for a personal loan, it’s important to understand the different rate terminology you’ll likely see in loan offers and contracts.
Fixed vs. Variable Interest Rates
Fixed and variable interest rates are the two types of rate arrangements you may see on a loan. A fixed interest rate remains the same for your entire loan term, resulting in fixed monthly payments. For example, if you qualify for a 10% interest rate when you apply for the loan, you’ll pay 10% per year until your loan is repaid.
On the other hand, a variable rate can change over the course of the loan, usually according to an index or a benchmark rate. If market interest rates fall, so will the variable rate on your personal loan. However, if interest rates rise, the rate on your loan is likely to rise too.
Most personal loans have fixed interest rates. While you may find some lenders that offer variable rates on personal loans, they’re more common on credit cards and lines of credit.
Comparing Fixed and Variable Interest Rates
Annual Percentage Rate (APR)
APR, short for annual percentage rate, is a term frequently used in loan agreements to refer to the interest rate, but it represents far more than that. Your loan’s APR is its overall annual cost, including interest and other fees.
The APR more accurately reflects the true loan cost than the interest rate alone. When comparing loan offers, look specifically at the APR to get the most accurate idea of which loans are truly the most affordable.
Pros and Cons of Low vs. High Personal Loan Rates
A low personal loan rate has plenty of benefits, including overall affordability. Meanwhile, higher interest rates have some key downsides.
Pros
- Lower monthly payments.
- Less total interest paid over the loan term.
- Easier to budget and pay off.
Cons
- Higher monthly payments.
- It is more difficult to pay down the principal quickly.
- Increased total interest paid over the life of the loan.
How to Qualify for the Best Personal Loan Rates
Your interest rate can significantly affect the overall cost of your personal loan. Luckily, there are a few steps you can take to get the best rate on your loan.
Improve Your Credit Score
Improving your credit score may be the most impactful thing you can do to qualify for a lower personal loan rate. While increasing your credit score may seem overwhelming, especially if you’ve been trying to for a long time, there are a few steps you can take to see quick change:
- Check your credit report for errors, and report any you find.
- Avoid late payments on your monthly bills and debt payments to improve your payment history.
- Pay down your existing debt to improve your credit utilization.
- Avoid applying for other new credit before taking out your personal loan, as the hard inquiry can lower your credit score.
- Consider becoming an authorized user on someone else’s credit card to allow their payment history to boost your credit score.
Shop Around for Lenders
Interest rates can vary significantly from one personal loan lender to the next. Shopping around for a loan can help you compare rates across many lenders and find the best one.
First, many lenders display their rates on their websites, which can give you a good starting point. Next, consider getting prequalified with some lenders, which allows you to get a rate estimate without a hard inquiry. Finally, consider using a personal loan marketplace that can show you offers from many lenders at once.
Remember to look at the APR when comparing loan offers, not just the interest rate. The APR best reflects the actual loan cost.
Opt for Shorter Loan Terms
As we mentioned, lenders tend to offer the best interest rates on shorter loan terms. If it’s in the budget, consider opting for a shorter loan term, even if it means a higher monthly payment. While the longer loan term might look more cost-effective because of the lower monthly payment, the additional interest adds up in the end.
Lower Your Debt-to-Income Ratio
Lowering your DTI can help lower your interest rate by making you a more attractive borrower to lenders. By lowering your DTI, you show lenders you’re better able to fit your loan payments into your budget. The best way to lower your DTI is to pay off some of your existing debt (usually by focusing on one debt at a time), but you can also lower it by increasing your income.
Take Control of Your Finances and Secure the Best Personal Loan Rates
Several key factors influence your personal loan rates, including your credit score, loan amount, loan term, DTI, and employment history.
When you’re looking for a personal loan, shop to find the lender that offers the best rate for your specific situation.
Showing your lender that you’re a qualified borrower who uses money responsibly is ultimately the best way to land a lower rate. The good news is that improving your credit score and debt situation will not only improve your personal loan rates but also help improve your finances overall.
FAQs
The best ways to lower your personal loan interest rate are to improve your credit score, lower your debt-to-income ratio, opt for a shorter loan, and shop around for the best offer when taking out a personal loan.
Depending on your situation, you may be able to negotiate your interest rate on your personal loan. Lenders may be more likely to negotiate with creditworthy borrowers. If you’ve applied for multiple personal loans, consider using a lower rate from a different lender as leverage.
The best APR on a personal loan fluctuates as the interest rate and loan markets change. A good rate may be considered as anything below 8%, though it’s also subjective based on your financial situation.
