Interest is the cost of borrowing money by taking out a loan. Lenders calculate your interest based on a percentage of your loan, which is called an interest rate. You might notice different rates when you’re shopping around with various lenders. That’s because many factors go into calculating this rate. In this article, we’ll dive into the four big factors that can impact loan interest rates so that you’re equipped to find a good rate on your next loan.
1. Credit score
Your credit score is a number lenders use to estimate your likelihood of successfully paying the loan back. It’s one of the biggest factors that can affect your interest rate. The higher your score, the lower the rates you can qualify for. Fortunately, there are several ways to improve your credit:
- Make all your payments on time: Your payment history is one of the biggest factors that affects your credit. Consistent on-time payments will improve your score and show lenders you can pay off your debts responsibly.
- Maintain several different types of accounts: Having a good mix of credit, such as loans and credit cards, can improve your score.
- Keep your card balances low: Your credit utilization ratio, or how much of your available credit you’re using, is an important credit score factor. Try to maintain a credit utilization ratio below 30% by paying down your balances and managing your spending.
- Don’t close old accounts: A longer credit history length can improve your credit and make you appear more favorably to lenders. Closing old accounts will decrease your credit history length and can lower your score.
- Minimize applications for new credit: Applying for multiple loans and credit cards all at once will cause hard inquiries, which can lower your credit score. So, try to limit the new accounts you apply for to limit the negative impact to your credit.
2. Loan size
Loan size can impact your interest rate as well. If you get a larger loan, you’ll need to make larger payments each month or get a longer term to pay the loan off successfully. Both of these can increase the lender’s risk, so you may get a higher interest rate. Getting a smaller loan may help you qualify for a lower rate.
3. Loan type
The type of loan you take out can also affect your interest rate. Secured loans like home mortgages or auto loans use a piece of property as collateral. This collateral reduces the lender’s risk, allowing them to offer you a lower interest rate. On the other hand, unsecured loans like personal loans don’t use collateral to back up the loan. As a result, your interest rate may be higher.
4. Interest rate type
Fixed-rate loans have an interest rate that doesn’t change. For instance, if you get a $5,000 personal loan with a 5% fixed rate, your rate will remain 5% for the entire loan term. These loans are often good choices when interest rates are low because you don’t have to worry about your rate increasing in the future.
Variable-rate loans have an interest rate that changes alongside a larger interest rate, like the Federal Reserve’s federal funds rate. These loans can work well if the initial rate is lower than a similar fixed-rate loan. But keep in mind that you may risk the interest rate increasing in the future.
The bottom line
Plenty of factors impact loan interest rates. Your credit score is one of the biggest factors, but loan size, loan type, and interest rate type can impact your rate as well. This makes it important to shop around and compare multiple offers. Regardless of your credit score, receiving multiple offers from different lenders can help you get the loan type and amount you need at a rate that fits your budget.
Notice: Information provided in this article is for information purposes only. Consult your financial advisor about your financial circumstances.
Name: Michael Bertini
Job Title: Consultant
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