Understanding what interest rates are and how they are applied to a loan is essential to making the best financial decision for yourself. With any type of secured or unsecured loan, such as a personal loan, mortgage, credit card, or auto loan, the interest rate will affect how much you pay over the life of the debt beyond the principal balance owed. Our ultimate guide gives you the basics of what interest rates are, how they work, and how they relate to APR.
What Are Interest Rates?
An interest rate is effectively the cost of borrowing money. A borrower pays interest on a loan in exchange for the ability to spend money now rather than waiting until they’ve saved the necessary amount over time.
How Do Interest Rates Work?
Typically, when a lender approves you to borrow funds, they will apply an interest rate to the total amount of your loan balance. Interest rates tend to differ between lenders and can fluctuate depending on several factors.
From the perspective of the lender, every loan granted comes with the chance that the borrower will fail to repay it. Banks and other lending organizations determine the interest rates they charge based on their assessment of the borrower’s risk of non-repayment. The higher the risk a borrower poses (i.e., the likelihood they will default, or fail to repay the loan), the higher their interest rate will be.
The type of debt you’re applying for also influences the interest rate you’ll get. Lenders will charge higher interest rates on revolving and unsecured loans such as credit cards, as they are not only more expensive to manage but also less likely to be repaid. Mortgage loans—secured loans backed by collateral (your home)—have a higher likelihood of repayment, and therefore qualify for lower rates.
Economic conditions and the federal rates set by the government can also influence loan interest rates. When the federal government lowers its benchmark rate, loan and credit card interest rates may be soon to follow. Keep in mind that if you have an existing fixed-rate loan, your interest rate will not change. However, if lenders anticipate a period of economic slowdown or instability, they may be less willing to lower their interest rates to help mitigate the risk of borrower non-repayment.
Types of Interest Rates
There are two main types of rates you’ll see lenders charge: fixed and variable.
Fixed rates are set in stone—as mentioned above, the interest rate you receive will never change throughout the life of the debt. At the beginning of repayment, a large amount of your monthly payment will most likely go towards paying interest. As time goes on, a higher percentage of your monthly payment will go towards the principal balance. The most common type of fixed-interest rate loans issued are home mortgages and personal loans.
Adjustable or Variable Rates
Adjustable rates, also known as variable rates, adjust periodically in line with an index like the prime rate (i.e., the rate banks charge their most low-risk, creditworthy customers—like large businesses). For example, let’s say you took out a loan at a 4% variable interest rate. After six months, it adjusted to 5%. Based on that 1% increase, your new interest payment and principal are calculated, and the unpaid balance of the loan adjusts. The most commonly issued types of variable rate loans are credit cards and home equity lines of credit (HELOCs).
What is an APR?
An annual percentage rate, or APR for short, is seen as a more accurate representation of the cost of debt, as it includes hidden costs such as broker fees, additional lending fees, or one-time fees known as “points.” Lenders calculate these as a percentage point of the total debt. Essentially, the APR tells you the total cost over the entire life of the debt, while the interest rate tells you what you’ll pay every month.
When comparing loans, it’s a great idea to use the APR as a gauge, especially when comparing a loan that charges a lower interest rate but includes points versus one that only charges interest. For example, a loan may have a fixed interest rate of 5%, which would give you a slightly lower monthly payment, but has an APR of 5.25%.
What Factors Do Lenders Consider When Calculating My Interest Rate?
You may have already known that your credit score plays a role in calculating the interest rate a lender offers you, but there are actually many different factors lenders also consider. While some factors are examined across all loan types (e.g. income and payment history), others are often weighed more heavily depending on the loan purpose and if it is backed by collateral.
Employment History and Income
Lenders want to see a stable employment history. If you’ve had the same job for a year or more, it’s a good bet that you’ll continue to work there and won’t lose your job. Stability in employment indicates a steady income, leading to a lower interest rate.
If you are carrying a lot of debt already, you pose a higher risk to lenders. A dip in your income could leave you struggling to pay all of your existing financial obligations, let alone a new one. With that in mind, the more debt that you already have when applying for a new loan, the higher your interest rate will likely be.
In general, the size of the down payment you put down is an indicator to the mortgage lender of your commitment to pay back the loan. As a result, with a higher percentage down payment, you’ll be viewed as less of a risk and be offered a lower interest rate.
Interestingly, where you’re buying a home also impacts the interest rate. More expensive housing markets typically mean higher rates.
Loan Term and Size
Typically, the shorter the loan period, the lower the interest rate. While you’ll likely have a larger monthly payment with a 15-year mortgage as compared to a 30-year mortgage, you’ll have a lower repayment cost overall. The same is true for the size of a loan: the smaller the loan amount, the lower the interest rate (generally).
Similar to mortgages as stated above—the shorter the loan period, the lower the interest rate you’ll be offered.
Age and Model of Car
The age of the car plays a significant role. While older cars come with higher rates to accompany their lower resale value, newer models have lower rates because they are attractive to the market.
Again, as with mortgages above, more money down means less risk for the lender—which translates into lower interest rates for you.
Type of Card
Those fancy rewards cards may look enticing due to their significant perks, however the advertisements never mention the downside—higher interest rates, i.e. the way the card issuers pay for those benefits. A basic, bare-bones credit card is likely to be accompanied by lower rates (but no sweet cashback perks).
Did you know most credit cards have a penalty rate? This means that if you’re late on your payments, issuers will charge you a higher interest rate regardless of your credit score.
How to Get the Best Interest Rate
What defines a “good” interest rate is relative, which is why it’s essential to compare and shop for rates not only with local brick-and-mortar lenders, but also online. Evaluate all your options before choosing the best rate for your financial situation.
Watch Out for Hidden Fees
Don’t let the allure of a low rate fool you: the money you save can quickly be outweighed by fees tacked on in the fine print. In addition to the interest rate, it’s essential to look at APR and any related fees charged.
Check Your Credit Before You Apply
It’ll come as no surprise, but your credit score matters for most interest rates. What you might not know is that issuers have created tiers based on credit score, and those with the highest scores typically receive the best rates for loans, credit cards, and mortgages.
FICO scores above 760 are usually offered the best rates. Still, every lender has their own criteria and tiers, making shopping around essential to making the best financial decision.
Now that you’re armed with the knowledge of how interest rates work, you can shop around with confidence for a personal loan with Credit Direct. Apply online to check offers through us and our trusted partner network with no effect to credit score.