Understanding loan interest rates is a worthwhile effort. Finding the best interest rate on loans leads to a lower cost to borrow, lower payments, and may even lead to a shorter repayment term.
However, many people do not understand interest rates on loans, never mind the factors that affect them. Luckily, you should understand both by the end of this article.
How Does Interest Work on a Loan?
Basically, the interest rate on a loan is the amount the lender charges you for borrowing money. It is defined as an annual percentage rate (APR). This percentage is applied to the amount you borrow, or the principal amount.
Can Lenders Calculate Interest in Various Ways?
Yes, lenders can charge you interest on personal loans in two ways: simple and compound interest. They are very different and one is far costlier than the other.
Simple Interest
Most lenders charge simple interest on personal loans. It is very easy to calculate and the cost is divided equally between your payments.
As an example, if you borrow $5,000 at an annual interest rate of 10% with a repayment term of one year, you will pay the lender $5,500. This includes the original amount of $5,000 plus interest calculated as 10% x $5,000, or $500.
It is important to remember that you pay this interest amount each year. If your loan repayment term is over three years, you pay $500 every year. In this case, you’d pay $5,000 + $1,500 in interest, or $6,500. However, you also have longer to repay, which lowers your payments.
Compound Interest
Some lenders use the compound interest method which costs you considerably more. The lender charges you interest on the principal and any interest that accumulated on your personal loan over the previous period.
For instance, after the first year you are charged interest on the principal for that year. However, at the end of the second year you are charged interest on the principal AND interest on this combined amount. Essentially, you pay interest on interest.
Compound interest calculations are complex, but one thing is clear. Personal loans using complex interest cost you more. The longer your loan term, the more your cost of borrowing amplifies since you’re always paying interest on the total from the previous period.
What Factors Affect the Interest Rate on Loans?
Of course, borrowers want low interest rate loans. Nonetheless, to find the best lenders and loans it does take some know-how.
Luckily, you have control over many of the factors that affect interest rates on loans. The following are those that could affect what you pay:
Credit Score
Many, but not all lenders use your credit score as a yardstick to determine your creditworthiness. The higher your credit score, the more likely you are to be offered a top interest rate on loans.
However, a less than ideal credit score does not mean you can’t borrow. You can find lenders for almost any financial situation. The catch is you will probably pay more interest. Low interest rate loans are often reserved for those with good or excellent credit.
Income
If you don’t have pristine credit, you can still borrow based on your income. It should be steady and recurring for serious consideration. A regular income can positively impact interest rates on loans.
Luckily, some lenders consider various income sources including self-employment, pensions, and disability. The income threshold for some lenders is also surprisingly low. You can apply to see the lender’s low-income installment loan interest rates.
Debt-to-Income Ratio
Understandably, lenders are reluctant to lend to individuals that carry a lot of debt. It increases the risk of defaulting on a loan. Consequently, lenders compare what you earn to what you owe to come up with a ratio called a DTI. You can calculate yours here.
Generally, the lower your DTI the better. If you want to get low interest rate loans, experts suggest a DTI of under 35%. Nonetheless, you can find lenders that accept a higher DTI. It will just affect your interest rate on loans.
Repayment Term
Interest rates on loans increase with the length of the repayment term. Longer loans are more risky, because there is more time for borrower default. Additionally, lenders charge more since their money is tied up during the loan period and can’t be used elsewhere.
Economic Conditions
Obviously, you can’t control this. The Federal Reserve sets the interest rate and lenders use this to determine the APR range they offer. A high prime rate leads to higher APR’s.
However, you can control when you decide to borrow. If there are hints that interest rates may drop, you may want to wait. If they’re set to rise, you may want to move quickly for the best personal loan interest rates.
Lender Chosen
Every lender decides on their lending criteria, loan products, and subsequent interest rates on loans. Some offer fast cash options, while others are painfully slow and meticulous. Many offer very similar products, but their interest rates vary drastically.
Remember, the APR a lender offers does not include fees and expenses. The best lenders in the industry do not charge an origination fee or prepayment penalties. However, it is up to you to do your homework if you want the best personal loan interest rates, without paying unnecessary fees.
Compare lenders that offer precisely what you need and be certain they use a pre-approval process. That way you compare personal loan interest rates, without affecting your credit score. One or two percentage points difference can add up to hundreds or even thousands of dollars in interest.
What Is the Average Interest Rate for Personal Loans?
Every lender and every borrower differs. As such, there really isn’t an average interest rate for personal loans. However, recent data from the Federal Reserve shows the interest rate on loans has risen significantly throughout 2022 and 2023.
Luckily, most personal loans have fixed interest rates. Once you lock yours in, it does not change throughout the repayment term.
Factors to Consider When Choosing a Personal Loan
Besides the interest rate on loans, you will also want to consider the following factors. They can narrow the selection process and make it more likely you’ll find the best loan for your needs.
Loan Amount
Decide how much you want to borrow beforehand. Some lenders offer small personal loans of $200, but the minimum for most is $1,000, or more.
Equally, if you’re looking for a larger loan the lender may not offer that much. Search for lenders that align with your needs.
Payment Amount
Once you know how much you want to borrow, check whether the monthly payment amount suits your life. There’s no point in getting a loan if your payments are going to make you miserable.
Loan Term
Lenders may offer a single loan term or many. If you’re borrowing a small amount, a year repayment term is very common. Larger amounts may merit a longer term, but remember you will pay more interest.
Urgency
Online lenders tend to faster and may offer lower APRs than brick-and-mortar lenders. However, you should always check their timeline for funds release. Even online lenders can have a slow loan process.
If you’re unfamiliar with online loans, applying for an online loan offers many other benefits over in-person borrowing. Nonetheless, you should always check that the lender has a license in your state. This ensures they follow the same rules and regulations as brick-and-mortar lenders.
If you’re not in a hurry, you may want to do whatever you can to improve your chances of getting the best loan interest rates. This includes checking all three of your credit reports and correcting any errors. You may also be able to add your phone, utilities, and some subscription services to your credit report if you need to build credit history.
Pre-Approval
The only way to find low interest rate loans is by applying through various lenders. We don’t recommend comparison websites, because they usually receive a kickback through affiliate links.
Interest rates on loans may be your primary deciding factor. However, pre-approval provides you with concrete information so you can separate potential lenders from unsuitable ones.
The Bottom Line on Loan Interest Rates
As you have read, many factors determine loan interest rates. Luckily, it is possible to get a decent rate, even if you don’t meet all the conditions some lenders demand.
Search for lenders that offer what you need and then check that they use a pre-approval process. Otherwise, multiple credit inquiries could lower your credit score. Apply for a loan with each and see what they’re offering.
For those looking for a fast loan process and less stringent requirements, FlexMoney may be able to help. We offer online loans of between $200 and $2,000, with one-year to repay. We use a pre-approval process that does not lower your credit score.