You’re now ready to begin the next phase of the loan application process: researching lenders. Naturally, you’ll want to look for lenders offering competitive terms and favorable interest rates to borrowers like you. This can be done with ease when you use an aggregator like Credible. They will provide you with rates from multiple lenders in just minutes.
You’ll also want to understand the factors that affect personal loan rates – and what they mean for your loan application. This knowledge empowers you to shore up your borrower profile before you apply for a loan by taking concrete steps like:
- Paying down outstanding revolving debt (such as credit card balances) to reduce your credit utilization ratio
- Pursuing side income opportunities to lower your debt to income ratio
- Identifying assets to put up as collateral against your loan principal
Interest Rate vs. APR
First, let’s review the difference between interest rate and annual percentage rate, or APR.
Your loan’s interest rate is the interest charge on its principal balance. It’s expressed as a percentage, such as 6% or 8%. The loan’s total numeric interest charge – the sum of the interest you can expect to pay over the life of the loan, assuming no prepayment – is a function of compounding frequency, or the frequency with which interest is calculated on the sum of the loan’s principal and accumulated interest. Total interest charges increase with compounding frequency.
Your loan’s APR incorporates interest charges and loan fees. It’s also expressed as a percentage and is always either equal to or greater than the loan’s interest rate.
The biggest fee personal loan borrowers need to watch for is the origination fee, which is expressed as a percentage of principal and is deducted from the principal before the loan is funded. For instance, net funding on a $10,000 loan with a 3% origination fee is $9,700: $10,000 principal minus $300 origination.
Some personal loan providers waive origination fees for well-qualified borrowers, but you may not be able to avoid paying one if your credit isn’t excellent. If you do need to pay an origination fee, your APR will be significantly higher than your stated interest rate. You’ll have an opportunity to review and compare interest rates and APR before making your personal loan application official.
Factors That May Affect Personal Loan Rates
As the following table makes clear, personal loan rates vary considerably by lender.
What accounts for all this variation? These are among the most consequential factors.
1. Credit Score & Lender
Your creditworthiness, as represented by your credit score, is the most important factor in determining your personal loan rate.
Much of the variation from one lender to the next is attributable to the types of borrowers these lenders pursue. Some lenders cater primarily to prime and super-prime borrowers, others cater primarily to near- and subprime borrowers, and some cater to a broad range of credit profiles. Lenders focused on the below-prime market typically have higher rate ranges than lenders focused solely on prime borrowers.
In any case, most lenders rely on the FICO scoring model to assess borrower creditworthiness.
Components of Your FICO Credit Score
Most lenders base credit underwriting decisions on borrowers’ FICO credit scores. The five main components of your basic FICO credit score are, in descending order of weight:
- Repayment History. This component accounts for 35% of your FICO score. Even a single missed payment is a significant demerit, so the best way to ensure a high number here is to make timely payments on all loans, lines of credit, and non-debt obligations that could affect your credit score, such as utility payments. If it’s available, enroll in autopay to reduce your chances of a missed payment. Your credit report contains payment information going back seven years.
- Credit Utilization. This accounts for 30% of your FICO score. It’s calculated by dividing your total revolving debt balances, such as credit card and home equity line balances, by the sum of your available credit lines. For instance, if your cumulative revolving credit balance is $5,000 and your total available credit is $15,000, your credit utilization ratio is 33%. Though some utilization is to be expected, lenders prefer lower credit utilization ratios. Strive to keep yours below 50%.
- Credit History Length. This accounts for 15% of your FICO score. All open credit accounts older than six months count toward your credit history length. So do accounts closed in good standing within the past 10 years and accounts closed as delinquent within the past seven years. The best way to ensure high marks here is to keep older credit accounts open, even if you don’t actively use them.
- Credit Mix. This accounts for 10% of your FICO score. The FICO model assigns lower risk to installment debt (such as a fixed-rate auto loan) than revolving debt (such as a credit card), though opening a credit card account or two won’t ruin your credit.
- New Credit. This accounts for the final 10% of your FICO score. To shore up your new credit rank, avoid applying for too many new loans or lines of credit at once.
In general, the higher your credit score, the lower your rate. Super-prime borrowers (those with FICO scores between 740 and 850) can expect rates within 3% to 5% of their lender’s advertised minimum, unless significant adverse factors lurk in the non-credit portion of their borrower profiles – for instance, a high debt-to-income ratio or spotty employment history. Subprime borrowers (those with scores below 619) can expect rates in the upper half of their lender’s advertised range – above 22% in a 9% to 35% range, for instance.
Lenders’ Proprietary Scoring Models
Every lender uses its own proprietary scoring model that incorporates credit and non-credit factors, though they usually don’t disclose these factors to borrowers. Because their model requires unwavering trust from retail investors, peer-to-peer (P2P) lenders like Lending Club and Prosper are more transparent with their scoring models.
Lending Club uses a detailed model to “grade” loans on a 35-tier risk scale. Its model utilizes credit and non-credit factors. Lending Club loans with the least perceived risk earn “A1” grades; loans with the most perceived risk earn “G5” grades. Each grade and sub-grade corresponds to a particular “adjustment for risk and volatility” that raises the tier’s effective interest rate above a constant base rate. For example, A1 loans’ adjustment value is 1.41%; G5 loans’ adjustment value is 25.94%.
2. Debt-to-Income Ratio
Your debt-to-income ratio is the sum of your debt obligations divided by your gross income. For example, if you have $3,000 per month in debt service payments and your gross monthly pay is $6,000, your debt-to-income ratio is 50%.
Most installment loans and credit lines, such as mortgage loans and credit cards, factor into your debt-to-income calculations. Some obligations that may affect your credit score, such as utility payments, don’t count toward your total debt. And you only need to account for your credit cards’ required minimum balance payments, even if you carry larger balances from month to month.
Mortgage lenders prefer debt-to-income ratios at or below 43%. Personal loan providers’ standards vary, but lower ratios are always preferred.
3. Employment Status & Income
Lenders prefer borrowers with stable employment and ample income. Actual minimum annual income requirements tend to be low – often in the neighborhood of $20,000 – but low-income borrowers rarely qualify for the best interest rates. Lenders generally look at 24 months of employment history but may go back farther.
Most personal loan providers that specialize in consumer loans prefer traditionally employed borrowers, as opposed to self-employed borrowers or solopreneurs, those with significant freelance income, and those who’ve recently started small businesses. As a self-employed person with good credit, I can personally attest that self-employed borrowers are at a disadvantage; my personal loan rates are several points higher than for traditionally employed borrowers with comparable income, and some lenders won’t give me the time of day at all.
The importance of educational attainment as a loan underwriting factor varies significantly. Some non-traditional lenders, such as Earnest and LendingPoint, overweight factors like education and employment while underweighting traditional credit factors. These lenders reason that younger borrowers with professional degrees and good job prospects are well-positioned to assume new debt, even if their credit history is spotty at the moment.
5. Loan Term
Longer-term loans (five to seven years) tend to have higher rates than shorter-term loans (one to three years). Longer-term loans are also more expensive overall since interest accumulates for longer.
6. Loan Principal
High-principal loans may have higher rates than low-principal loans since they entail more risk for lenders. However, many lenders simply won’t fund high-principal loans for borrowers they deem unqualified. If you have fair or even good credit, as opposed to excellent credit, you may find your loan offers capped below where you’d like them to be.
Secured loans – loans guaranteed by assets the borrower must forfeit in default – invariably have lower interest rates than unsecured loans, which are far riskier for lenders.
Most personal loans are unsecured, however. If you’re considering taking out a personal loan to cover an expense that may also be financed with a secured loan, investigate your secured options first.
For instance, new and certified used car buyers routinely finance purchases with secured loans issued by banks, credit unions, and specialized auto finance companies. Since they’re guaranteed by the underlying value of the vehicle, secured car loans typically have lower interest rates than unsecured general-purpose loans that might finance a private-party vehicle purchase. A few years back, I took out a secured vehicle loan at about 3.3% APR, at least two percentage points lower than prime unsecured loan rates at the time.
8. Loan Purpose
By itself, your loan’s specified purpose doesn’t directly affect its rate. Much as your lender might like to control how you dispose of your loan’s proceeds, it doesn’t have that power. All it can do is take your word that you’re going to use your loan as you say you will.
That said, some lenders don’t advertise loans for specific purposes. Play around with the “Loan Purpose” variable in our loan table above, and you’ll see what I mean.
More importantly, a personal loan isn’t the best fit in every single circumstance. If you have excellent credit and a modest existing debt load, for instance, you may qualify for a 0% APR credit card balance transfer offer that lasts long enough for you to pay down your outstanding balance without incurring any further interest charges. Under those circumstances, taking out a personal loan – even at, say, 6% or 8% APR – doesn’t make financial sense.
9. Benchmark Rates
Personal loan providers don’t set rates in a vacuum. Like other lenders, they adjust retail rates in response to changes in underlying benchmark rates, such as the LIBOR (London Interbank Offered Rate).
Benchmark interest rates turn on a variety of macro factors, such as inflation rates and expectations of economic growth. In general, interest rates rise in high-inflation, high-growth environments and fall in low-inflation, low-growth environments. According to the Federal Reserve Bank of St. Louis, the LIBOR languished below 0.6% during an extended period of low inflation from late 2009 through late 2015, then rose steadily as prices increased, peaking above 2.8% in late 2018.
Every lender follows its own proprietary loan origination process, and seemingly trivial differences in borrower scoring models may produce noticeable changes to offered loan rates and terms. As you hunt for the lowest possible personal loan rate, do yourself a favor and check your rates with as many different lenders as you can. You might be surprised to find a great deal hiding in plain sight.
Are you in the process of applying for a personal loan? Who’s offering the best rate?