Truth Revealed: Here’s How Lenders Determine Your Interest Rates

Loans could save you at the time you are stuck with some huge project. Think of completing your apartment to start receiving offers from potential tenants.

Usually, when you borrow money from any lending institution, you will be charged a fee on top of the principle. This fee charged is the interest.

But as a borrower, you may be curious to know how or who determines your interest rates and why. The sad news is that most banks will not disclose this to you in detail.

The good news though is that I can offer you the best thing right now, right here. And, if you could be wondering what that best thing is.

Surprise surprise — It’s the five ways lenders use to determine your interest rates.

Let’s jump right in.

1) Your Credit Score

In case you didn’t know; a credit score is a three-digit number that shows how likely you will pay your debt. It is typically used by financial institutions whenever they want to give you a loan.

But why is your credit score important and how does it relate to the interest rate?

Your credit score will have either a positive or negative impact on your interest rate. If your credit history shows that you’ve been paying your bills in time, then you will have a good credit score, which will help you secure low-interest rates.

On the other hand, if you have always defaulted in payment, it means you will have a bad credit score, which will oblige you to only qualify for high-interest rates.

The good news is that you can improve your credit score by paying your bills on time and avoiding credit card balances.

2) Your Debt-to-Income Ratio

You keep on borrowing, and because you have an option of a minimum payment, you decide to go that route, thinking you are safe.

The bitter truth is that you are adding salt to your injury. Why?

When you keep on carrying forward your balances, your debts increase and then become more than your income — so, you end up paying bills recurrently.

Banks or any other lending institution will be skeptical with you because of your unsettled debts.

So, to ensure they take care of the risk of you not paying back your loan, they will impose a higher interest rate compared to someone who has more income than debts.

In a nutshell, try to have as little debt as possible and more income. That way, the banks will have confidence in you that you’ll pay back your loan, thus charging you a lower interest rate.

3) Amount You Borrow and the Down Payment You’ll Make

Sometimes, it’s not about whether or not you will pay your loan. It’s about how much you will pay up front. If what you’ll pay up front is decent, then your lender will charge you a lower interest.

On the other hand, if what you’ll pay up front is low, then your lender will have to charge you a higher interest to cover for the risk.

Look every financial institution is in business, and no entity loves to go at a loss. After all, if they were comfortable making losses, then they wouldn’t be existing.

In short, you can pay more cash to secure a lower interest rate. So, next time you are planning a house, ‘buy down’ the interest rate by paying more and obtain a low-interest rate.

4) Length of Term

Lenders are comfortable with borrowers who need loans on a short-term basis. As stated earlier, lending institutions are in business, and their main aim is to make profit as fast as possible.

So, if you can pay your loan within the shortest time possible, they’ll do you some favor by trimming your interest rates.

But, you must be prepared to pay high amounts if you are opting for short-term loans. The deal will best suit you if you have an emergency and you are confident you can pay your mortgage within a short time.

On the other hand, if you want a long-term payment plan, your lender will be forced to charge you higher interest rates because to get their money back as quickly as possible.

5) Age of Your Car (Auto Loan)

In case you don’t know what an auto loan is; an auto loan is a loan you take to buy a car. Typically, they are determined by the value of the vehicle you wish to purchase.

That means, if you are taking a loan to buy a new car, you will be charged a lower interest rate when paying your loan because a new car has a higher value compared to a used car.

On the other hand, if you are taking a loan to buy a used car, your lender will charge you a higher interest because an old car has already depreciated.

Generally, it’s not a good idea to take a loan to buy a private car. Honestly, that’s not an investment; that’s luxury, which won’t generate more income. It’ll incur you more expenses such as fuel fees, maintenance fees, etcetera.

6) Use of Your Property

Lastly, lenders will consider the purpose of your property to determine your interest rate. So, if you have been requesting for loans without considering this factor, please do next time you want to take a loan.

For example, if you plan to have the home as a rental for tenants, then you’ll have higher interest rates. On the other hand, if you’ll occupy the house yourself, the bank will charge you a lower interest rate.

Wrap Up

During the time you need a loan, you are considered desperate. Therefore, you may not be curious to know how your lender determines your interest rates. But the worst scenario is taking a loan and being charged an interest rate you don’t understand.

It sucks. But you are lucky because at least you now know how some lender if not all determine your interest rates. The insights above should make you prepared if you want to take a loan.