What factors affect personal loan interest rates?

A personal loan is an affordable, convenient way to get the money to pay for emergency expenses, renovate your home, consolidate debt, fund a new business, or achieve other goals. These loans are very versatile, and personal loan requirements can vary by lender. To choose the best personal loan for your needs and get a reasonable rate, it's a good idea to learn more about the factors that could impact personal loan interest rates. Banks, credit unions, and other financial institutions often consider borrowers' credit scores and reports, incomes, debt-to-income ratios, collateral, available documents, and benchmark rates to determine interest rates.

Why your interest rate is important

The interest rate for your personal loan, also called the annual percentage rate or APR, can impact your monthly payment amount. It's the percent of what you borrow that you pay in interest every year. Personal loans can be between $1,000 and $50,000. You can choose a repayment term that's one to five years long.  Your rate and term can have a big impact on the total cost of your loan.

For example, a borrower might pay 6.24% APR for a $5,000 loan with a one-year term. For 12 months, they would pay $14.25 in interest per month. The total interest would be about $171.

With a 2-year or 24-month loan and a 7.24% interest rate, a borrower would pay $224.41 per month, about $16.05 per month in interest and the rest in principal. They would pay a total of $385.78 in interest. For many people, paying a slightly higher rate for a longer term and more affordable payment is worth it. Getting a lower interest rate could save you hundreds or even thousands of dollars over time with a larger loan. Here are some of the factors that could impact your APR.

Credit score and history

Your credit score is one of the most important factors that lenders consider before offering interest rates and other terms for a personal loan. You could get a better rate and lower monthly payments with a higher credit score. Although ranges vary depending on the credit scoring model, generally, these are the categories of credit scores:

• 720 to 850 – excellent
• 690 to 719 – good
• 630 to 689 – average or fair
• 300 to 629 – low

Your credit score is based on your credit history, and you can get detailed copies of your credit reports from the three credit bureaus: Equifax, TransUnion, and Experian. Checking your credit score lets you predict the monthly payments for your loan and compare rates from several companies easily. With credit reports, you can check for any errors and dispute them if necessary. To increase your credit score, be sure to make payments on time consistently.

Income

Most lenders impose income requirements on borrowers to make sure that they can make payments for their loans on time. Be prepared to provide proof of your income. This proof could include:

• Recent tax returns
• Monthly bank statements
• Pay stubs
• Signed letters from employers
• Contact information for employers

If you own your own business or are self-employed, lenders may accept a signed profit and loss statement.

Debt-to-income ratio

Your debt-to-income ratio (DTI) is a percentage that represents the part of a borrower's monthly income that goes toward their monthly debt. DTI helps lenders predict potential borrowers' abilities to make payments. A DTI of less than 36% is best, but lenders sometimes approve people with DTIs of up to 50%. This information is part of borrowers' credit reports.

Collateral

With a secured personal loan, the lender accepts an asset as security for a loan. This asset could be a house, a car, a savings account, a CD, an investment account, or valuable collectibles like a coin collection. Borrowers agree that if they fall behind or default on their payments, the lender can take possession of collateral to pay debts.

Personal loans are often unsecured, which means borrowers don't need collateral. If they can't pay for their loans, they won't lose any possessions. However, they could hurt their credit scores if they have any late payments or default. Secured loans can be easier to qualify for, especially for people who don't have high credit scores, and they may have lower interest rates.

Available documents

You'll usually need to fill out a form with basic personal information and send the lender copies of the documents. People usually give lenders:

• How much they want to borrow
• The reason for the loan
• Two forms of government-issued identification, such as a driver's license and passport, to prevent identity theft or fraud
• Proof of their address, like a recent utility bill, a copy of a rental agreement, or proof of insurance that lists their address

Benchmark interest rates

Loans with variable rates that are connected to a benchmark rate are available. Most lenders in the United States use the rate set by the Federal Reserve. People often call this the prime rate because it's the lowest APR available. As this rate changes, the APR of a variable rate loan also changes. Rates for new fixed-rate loans can change with the prime rate as well, but when you agree to a fixed rate, you keep the same APR and payments for the life of the loan. 

To discover more about personal loans, take a look at these articles as well:

• How do personal loans impact your credit score?
• 3 things you want to know about personal loans
• What is an unsecured personal loan?