When you are seeking out a loan, be it a mortgage, a loan to buy a car, guarantor loan, even a credit card, there are some components to borrowing and lending that are universal.
* How much you are asking to borrow or loan amount
* Interest rate or APR/annual percentage rate
* Term of the loan, or how long you are borrowing the money for
These components all go together, along with a few other lesser critical pieces, to make up your loan.
A question that many borrowers ask is, what will be the interest rate on my loan? How is the interest rate calculated or determined?
As we will see, the bottom line is that things like the interest rate are determined by the lender using a variety of ways and formulas, and while we have some say in this, it really is mostly in the lender’s control.
Interest rates for loans are usually represented by APR or annual percentage rate.
APR’s are the interest rates represented over a 12 month period.
The FCA or Financial Conduct Authority, who regulate all things credit define APR as:
“APR stands for the Annual Percentage Rate of charge. You can use it to compare different credit and loan offers. The APR takes into account not just the interest on the loan but also other charges you have to pay, for example, any arrangement fee. All lenders have to tell you what their APR is before you sign an agreement. It will vary from lender to lender.“
This is one reason why some interest rates for some loans, such as payday loan, seems so high.
Payday loans are short-term loans, usually 30 days or less, so when you express the interest rates over a 12 month period, they blow up to 1500% or 2000% or higher.
In looking at what determines the interest rate one may receive for a loan, we need to review these components:
Credit Score: Credit scores ar used not just to determine if a loan is approved or not, but also to determine what interest rate a borrower may receive.
The higher a borrower’s credit score is, the better or lower interest rate they may receive for a loan.
A lower credit score may mean a higher interest rate.
This is due to risk to the lender. A borrower with a low credit score is a higher risk in the eyes of a lender.
The Lender: The lender themselves can have an impact on what interest rate a borrower receives. Different banks and lenders have different interest rates.
Lenders also may tier their interest rates, a different interest rate for higher credit scores, and also tiered for the type of loan, loan amount, and the term of the loan.
Type of Loan: Different loans may have different interest rates. Just as a payday loan has a igh APR/interest rate, a mortgage or other secured loan will have a lower interest rate.
Secured loans historically have had lower interest rates as the loan is secured, and the lender has less risk of default on the loan.
Term of the Loan: The length of the loan, or term of the loan influences the interest rate as well.
Shorter loan terms for some loans, such as a 12 month loan, will have a lower interest rate as the lender gets their money back in a quicker time-frame.
Payday loans aside, because even though they are a short-term loan, they are a bad credit loan, and as such are a high risk loan to a lender.
Loan Amount: Some larger loans, such as mortgages, can receive a lower interest rate not just due to the fact they are secured, but a higher interest rate on large loans can make them unaffordable to the borrower.
As we can see, as a borrower we do not have control over many of the components that are used to determine the interest rate on a loan. However, we can control our credit scores, and by improving or raising them, we can receive a better, or lower interest rate.