Do you need to pay for a major purchase but you’re not quite sure how you’ll be able to afford it? Don’t worry, it’s happened to all of us at one time or another. The good news is you’ve got options, like applying for a personal loan.
Personal loans can help you borrow money from a financial institution like a bank, credit union, or online lender that you’ll pay back with monthly payments.
Personal loans are flexible and can be used to pay for all types of expected and unexpected financial pickles (think: home improvements, weddings, medical emergencies, or high interest debt consolidation).
However, preparing for a personal loan application process can sometimes feel overwhelming. Between gathering documents, researching personal loan lenders, and submitting your information to get prequalified, it’s easy to overlook essential details of your loan. One of the most essential details that can be overlooked is the personal loan interest rate.
To help you make the best financial decision possible, let’s take a quick look at what personal loan interest is, how it’s determined, and how it’s calculated.
What is an interest rate?
While financial institutions are happy to help qualified borrowers by granting them personal loans, they still need to make money. How? Borrower, meet the interest rate—the yearly cost you’ll be charged from your lender for borrowing money.
Interest rates, which are usually expressed as percentages, are unique to each borrower. That means the rate a person gets depends on several factors, which can vary by lender. (We’ll break this down further below!)
Variable vs. fixed interest rate
Lenders often offer two types of interest rates: fixed interest rate or variable interest rate. For a fixed interest rate, the monthly rate that the lender offers and the borrower accepts is the same throughout the life of the loan.
In comparison, a variable interest rate, while it may initially be lower, will increase and decrease as the market fluctuates over time. If the rate increases, it means your monthly payment will go up and you’ll end up paying more in interest over your loan term.
Personal loan APR vs. interest rate
People often use APR and interest rate interchangeably. It’s true they’re both expressed as percentages, but they’re not the same. APR, which stands for Annual Percentage Rate, encompasses a broader view of what the total cost of borrowing money will be compared to interest rate.
You can think of your interest rate as a stand-alone cost. But think of APR as an umbrella term since it’s the total cost of the loan, which includes the interest rate and other fees your lender may charge. Since the APR is a combination of several different costs wrapped up into one, it’ll reflect a higher number than your interest rate.
Pro tip: The Truth in Lending Act (TILA) requires lenders to disclose to borrowers both the interest rate and APR. You’ll find them in the loan estimate and closing disclosure.
How do interest rates work?
The interest rate you’re offered for a loan in the U.S. depends on two main forces: the U.S. central banking system and the Fed (The Federal Reserve), and the banking industry.
The Central Banking System and Federal Reserve
Technically, loan rates start with a baseline, which the Federal Reserve (Fed) determines. In the simplest terms, the primary purpose of the Fed is to keep the country’s economy running smoothly. Not too hot, not too cold, but just right–kind of like Goldilocks’s perfect bowl of porridge.
When the economy explodes and “gets too hot,” inflation can skyrocket and throw off the country’s economic balance. (Reminder: Inflation refers to an increase in prices of goods and services.) During hot, inflationary times, the Fed raises interest rates, which ultimately helps to simmer down the economy and promote the right kind of growth.
The banking industry
Banks use the interest rates set by the Fed as a baseline for the interest rates they offer. This baseline, combined with details unique to each borrower, help banks determine the borrower’s eligibility and final interest rate they may offer. Although the details that personal loan lenders collect may vary, they generally review personal details like a borrower’s credit report, credit score, annual income, and the loan size and repayment period requested.
These details provide lenders with a full picture of your financial health. If you’re not financially healthy, you’ll be considered a risky borrower, which means you may be offered a loan with a higher interest rate, or you may not qualify for a loan.
How do I get the best personal loan rate?
The best personal loan rates (aka the lowest personal loan interest rates) are usually granted to borrowers with a great credit score, a healthy financial history, a secure income, and a low amount of debt.
If your financial standing isn’t where you want it to be and you think it may hurt your chances of qualifying for a personal loan with a decent rate, there are steps you can take to prepare.
Check your credit score and credit report
Your credit score is one of the single most important factors that’ll impact your loan rate. Why? It determines your creditworthiness, which means that it acts as a financial health grade for lenders to help them understand how responsible you are about managing your finances. If you have a low credit score, your lender will likely give you a loan at a higher interest rate, or may not approve you for a loan.
Before applying, check your credit score and your credit report. A credit report is a financial transcript that includes your debt, credit history, and credit score. Order free copies of your reports from the three major credit bureaus and check them to see what might be hurting your credit score. Address the issues to improve your credit score before you apply for a loan. Improving your score now will help you qualify for better personal loan interest rates in the future. Credit scores can range from:
- Excellent credit: 800 – 850
- Very good credit: 740 – 799
- Good credit: 670 – 739
- Fair credit: 580 – 669
- Bad credit: 300 – 579
Get a co-signer
In some cases, lenders may grant loans to borrowers with less-than-good credit, but the interest rates could be high. If you find yourself in this situation, consider adding a co-signer to your loan as it could help you qualify for a lower rate. You can have a friend or family member with good credit sign the loan with you. Be aware that if you don’t make your loan payments, your co-signer will be responsible for making payments.
Make sure there are no added fees
Many lenders typically charge extra fees in addition to the interest rate—like an application fee or origination fee. When you’re looking for a lender, ask them in advance about any fees they charge. Why? If you opt for a lender that doesn’t charge those fees, you’ll be able to avoid paying an interest amount that is inflated by those fees.
Lower your loan amount and repayment period
Asking a lender to borrow a large sum of money or for a long repayment term increases the amount of risk a lender will be taking on you. If your lender considers you or your loan request to be too risky, they may offer you a loan, but with a higher interest rate to compensate. By lowering the amount you’re asking for or your repayment time, the lender may see this as less of a risk for them and could possibly offer you a lower rate.
Take advantage of loan discounts
Some lenders offer interest rate discounts for different reasons. For example, many online lenders offer autopay discounts while other banks offer discounts to longtime customers that have specific types of bank accounts. Ask your lender before you commit to the loan to make sure you’re getting the best deal possible.
Think about your loan options
There are two types of personal loans you can apply for—a secured loan or an unsecured loan. With a secured loan, lenders require borrowers to back up the loan with collateral, which is an asset with considerable value like a car, home, or boat. The asset serves as a form of repayment insurance for the lender.
By adding this layer of security to the agreement, the lender minimizes their risk because they can seize the agreed upon asset if the borrower defaults on their monthly loan payments. Since a secured loan has collateral attached to the agreement, they tend to have a lower interest rate and can be easier to get.
Unsecured loans don’t have any extra layers of security like collateral, which can make them harder to get if you don’t have a good credit score. Additionally, these types of loans tend to have higher interest rates and/or shorter repayment terms.
How is interest calculated on a personal Loan?
Each monthly loan payment is made up of two parts—the principal (the amount you borrowed) and the interest (the cost you’re paying to borrow).
With a fixed rate loan, your monthly payment will remain the same for the entire loan term, but in time, the amount you pay in interest and principal will change. Sound a little confusing? Let us explain.
When you initially start paying for your loan, the amount you pay in interest is higher since the total balance is higher. As the balance shrinks, the monthly interest payments will decrease too, and more of your payment will be spent on paying off the loan principal.
If you’re someone who prefers a visual example, Figure 1 demonstrates how interest amounts you pay change over time. The example below provides a 6-month snapshot of a 12-month personal loan amortization schedule for a $3,000 loan with a 15% interest rate.
Pro tip: An amortization schedule refers to a layout of how much you’ll be paying each month in principal and interest over the life of your loan.
|Personal Loan Amortization Schedule|
|Payment Month||Total Monthly Payment||Principal||Interest||Remaining Balance|
While we highly recommend using a personal loan rate calculator, you can do it the old school way and calculate the monthly interest payment yourself in two easy steps.
Step 1. Start by calculating the monthly interest rate of the loan. To do so, divide the annual interest rate by the loan term in months. For example, using the loan details above, divide 15 (the interest rate) by 12 (the loan term in months) to get 1.25%.
Step 2. Calculate the monthly interest payment. Multiply the result from Step 1 by the loan balance for each month. So, your first month’s interest payment would be 1.25% (calculated as .0125) x $3,000, which will come out to or $37.50. The second monthly interest would be 1.25% (calculated as .0125) x $2,766.73, which would come out to $34.58.
Now, it’s time to get personally invested
Money is a personal matter and it’s worth exploring ways to improve your financial well being. You could save yourself a lot of money by taking the time to understand what an interest rate is, its impact, and how it’s calculated.