When life’s expenses squeeze our wallets a little too tight for comfort, unsecured personal loans can give us the breathing room needed to splurge on that dream vacation, wedding, or kitchen remodel. But the total loan amount sways to the fancy of one critical element: your interest rate.
Interest; that nagging monthly fee for the privilege of borrowing. When these loans pose no collateral and fixed terms, it forces the lender’s hand to tack on a higher interest rate to temper the gamble of repayment. However under this umbrella of risk, it’s important to understand why your unsecured personal loan interest rate is what it is.
Your Credit Report
Your credit has a direct link to how much interest you’ll pay. While a lower score won’t necessarily prevent you from getting a loan, it’ll make it more expensive to manage. Your credit is all that a lender has to determine if you’re going to be a reliable borrower. This track record says a lot about you, especially when a lender is deciding whether or not to fork over a large amount of money.
Through a lender’s eyes, consider Borrower A and Borrower B. Borrower A’s credit report reveals a student loan debt, two credit card balances that add up to $400 and a handful of late payments. Borrower B has a timely payment pattern with one credit card balance of $100 and just one late payment from his early days of card use.
If it was your money, who do you have more confidence will pay you back? Borrower B will most likely receive the lower interest rate. Because this is one element that you have some control over, make the necessary adjustments you can to clean up your credit history for the sake of a lowered interest rate.
Your Debt to Income Ratio
Lenders want to know that what you earn can not only comfortably cover the cost of the loan, but also that your existing debts aren’t eating so much of your income that you can’t afford to repay the loan. Typically, loan installments must be less than 35 to 40 percent of your monthly income.
Although a higher income represents a lower risk of default, it’s not as critical as the proportion of debt that you have compared to your income. Lenders like to see this ratio below 30 percent to ensure that you don’t have more debt than what you make. A larger debt ratio can translate to a smaller loan in addition to higher monthly interest.
When you’re in the market for an unsecured loan, paying off as many debts as possible before you sign on the dotted line will help you reduce your debt-to-income ratio to secure a lower rate.
The Lender’s Policies
When you do a little bit of homework between lenders, you’ll find a wide range of interest rates. While a credit union may have a 7 percent interest rate, a bank may offer a 5 percent rate. Online services like ClicknLoan can take care of the rate comparisons for you.
Banks and lenders have loan pricing models based on operating costs to provide the loan, funding through deposits or money markets as well as the need to meet a certain profit margin. However, competition with other lenders can come into play in your favor. The Federal Reserve lets banks borrow money at a particular rate, which causes banks to change their offers daily.
Duration of the Loan
Time plays a critical factor in the interest rate of your loan. A longer loan period means that lenders are dealing with the increased risk of prolonged separation from their money. The result is a higher interest rate.
The good news is that unsecured loans are coupled with repayment periods that are usually shorter than their collateral counterparts—about one to ten years. But no matter what the loan term period is, it’s ideal to instill a solid payment plan to repay the loan as quickly as possible.
While a prepayment penalty is typically reserved for a secured loan like a mortgage, check in the fine print of your loan to ensure that your good intentions to repay faster and cut back on interest aren’t met in vain.
You may not be able to predict how the market will influence your unsecured loan’s interest rate. But with careful planning and an understanding of the additional factors that shape your rates, you have a greater chance of coming out on top.
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