How are interest rates determined?
Imagine two people - Jane and Bill - apply to borrow the same amount of money. They have similar incomes and debt, but Jane receives a lower interest rate. Why would her rate be lower? Although it might seem unfair, there are guidelines that determine interest rates. We often hear about credit scores, but what other factors are considered?
As mentioned, your credit score is a major consideration when a lender determines interest rates. Think of your credit score like a report card that grades how you’ve handled your debt. Generally speaking, the higher your score, the lower the interest rate you’ll be charged. Credit scores range from 350 - 850, and credit scores from 670 - 700+ are usually considered good.
Loan and Credit History
If you’ve paid your loans on time in the past, you’ll likely qualify for a lower rate. The longer your credit history the better, as a ten year record provides more information than one that covers three years.
You’re entitled to a free copy of your credit report every year, and we recommend checking it before you apply as it’s easier to address any problems before you’ve started the application process. A great source for learning about scores, filing disputes, and building/repairing/maintaining your credit is provided by the FDIC.
Your Credit Score and History are combined with your savings and other assets to determine your Creditworthiness, or the extent to which someone is considered suitable to receive financial credit. Creditworthiness is often a reflection of the lender's perceived risk of not being repaid - the more likely it is the lender believes you can and will pay them back, the lower the rate they'll charge.
The amount of debt you have is used to determine your Debt to Income Ratio. (Sometimes referred to as “DTI.”) The higher your current debt payments (other monthly bills are not considered), the higher your interest rate is likely to be. For example, if you earn $100,000 a year and pay $60,000 toward debt, your DTI is 60%. If you earn $100,000 and pay $20,000, your DTI is 20% and you’re considered more likely to be able to afford additional debt. A DTI of 40% or less is ideal. If your debit to income ratio is currently above 40%, you can lower it by paying down your debt or increasing your income.
As a general rule “secured” loans – loans guaranteed by property or other collateral – charge lower rates than “unsecured” loans. One easy way to remember this is to think about mortgage rates vs. credit card rates. It’s not unusual to see mortgage rates advertised at 5% or less, while advertised credit card rates are often as high as 35%. This is a reflection of risk for the lender - if there's collateral, they're less likely to lose money and so the less they'll charge in interest.
An important factor in your interest rate is where you’re applying for a loan. A "traditional" lender like a bank will likely charge less than a "subprime" lender like a finance company. No matter where you're applying, it's a good idea to get pre-qualified before submitting a final application. Being pre-qualified doesn't require a "hard pull" of your credit like a final loan application, so it won't affect your score but will give you an idea of the interest rate you'll be charged and identify any potential issues. Before you apply for a line of credit (like a credit card) be sure to compare interest rates as they can range anywhere from 0% to more than 35%.
Play the FDIC's Money Smart Credit Game
Understanding Your Credit Score
Check Your Potential Mortgage Rate
As you can see, there are many factors used to determine interest rates. If you have questions about interest rates – especially as they pertain to your loan – be sure to talk to your lender. Typically they are happy to discuss the rate they’re quoting, as well as anything you can do to earn a lower rate.
The views, information, or opinions expressed in this article are solely those of the author and do not necessarily represent the views of Citizens State Bank and its affiliates, and Citizens State Bank is not responsible for and does not verify the accuracy of any information contained in this article or items hyperlinked within. This is for informational purposes and is no way intended to provide legal advice.