Personal loans can be used for a variety of purposes. Whether it’s a new deck, a kitchen remodel, or debt consolidation, a personal loan provides borrowers the financial means to make it happen. Lenders advertise personal loans everywhere, typically stating a range of interest rates available, which may leave potential borrowers wondering, “Why is there a range, and how do they determine an applicant’s interest rate?”
There are five main factors that determine the interest rate for a personal loan:
Unsecured vs. Secured
Personal loans are typically unsecured loans, which means that borrowers do not have to supply any physical possessions as collateral that could be repossessed if the borrower fails to make their payments. Unsecured personal loans typically carry a higher interest rate.
Applicants are required to give proof of their ability to repay the loan. If an applicant’s financial situation shows that making payments may be difficult, the interest rate may be higher, or the loan application may be denied altogether.
An applicant’s credit score and payment history provides a lender with information regarding the likelihood that the loan will successfully be paid back. A borrower that has a history of making their payments on time will be offered a lower interest rate than someone who misses payments frequently.
Credit utilization is the measurement of how much of a potential borrower’s current credit is used. If an applicant has a credit card with a limit of $5000, and the current balance is $4900, the applicant has a high credit utilization. If an applicant has a high credit utilization, their application may be denied, or the interest rate offered may be higher.
An applicant’s credit history shows their ability to handle credit accounts. If the applicant just paid off an automobile loan, has a mortgage, and has had credit card accounts in good standing for the last 10 years, that reflects their ability to successfully handle credit accounts. On the other hand, an applicant who does not have a mortgage and has never had a credit card makes it harder for a lender to determine how the applicant will handle a loan, therefore affecting the interest rate offered.
The common theme in all of these factors is risk. All of these factors are measuring sticks used by borrowers to evaluate the likelihood that they will be repaid the money they loaned. The higher the risk, the higher the interest rate offered. The reasoning behind this is really the law of averages. If 10 borrowers who are considered high risk are given loans, maybe two of them will default and the borrower will never be repaid. The interest rate on the remaining eight is high enough so the borrower continues to make a profit.
Personal loans can provide borrowers the financial flexibility to enhance their lives or achieve some financial goal. Even if a potential borrower may be considered a higher risk, they may still be able to qualify for an unsecured personal loan at a higher interest rate.
Travis Pizel is a personal finance blogger who also writes at Enemy Of Debt, where he shares his family’s financial experiences, struggles and successes. As a father and husband, he provides a unique perspective on balancing debt, finances and family.