Overview
When you take out a loan, credit card, or line of credit, you’ll likely owe interest, which is essentially the price you’ll pay to borrow money. The lower your interest rate, the less you’ll spend on interest over time.
A higher rate, on the other hand, might mean hundreds or even thousands of dollars more in interest charges. Understanding how rates are calculated can help you lock in lower rates and reduce your overall cost of borrowing.
Below, let’s explore all the factors lenders may consider when determining your rates.
Key Takeaways
While your credit score is usually one of the key factors lenders look at when calculating rates, your debt-to-income ratio and down payment are also important.
Factors that are outside of your control, like inflation and the Federal funds rate, may also affect your interest rates.
To secure the lowest rate for your unique situation, it’s a good idea to shop around and compare multiple loan options.
7 Factors Lenders Use to Set Interest Rates
Each lender has their own method for calculating interest rates. However, most lenders will look at the following factors:
1. Credit score
Your credit score is a three-digit number (usually between 300 and 850) that shows how likely you are to repay the money you borrow.
A higher credit score positions you as a responsible borrower and leads to lower rates, while a lower score reveals you might struggle with timely repayments and, in turn, increases your rates.
Pro tip: You can use free credit monitoring tools to find out your credit score. If you need to improve your score so you can land better interest rates, pay all your bills on time, repay your debt, keep old accounts open, and don’t apply for new credit unless you absolutely need to.
2. Debt-to-income ratio
Lenders often use your debt-to-income ratio to measure how risky you may be as a borrower. Most of them prefer a ratio of no more than 43%. To calculate yours, divide your total monthly debt payments by your gross monthly income.
If you find that your debt-to-income ratio is high, lenders may be hesitant to lend you money because you’re already using a lot of your income to pay your bills.
Pro tip: To lower your ratio and increase your chances of more competitive rates, pay down existing debt, refrain from taking on new debt, and consider refinancing or consolidation.
3. Employment history
Before they extend a loan offer, lenders want to see that you’ll have the funds to pay back your loan. That’s why many of them will ask for your employment history and sometimes pay stubs or tax forms. If you’re unemployed or have many gaps in your resume, lenders might be concerned about your ability to make your payments and charge you a higher rate as a result.
Pro tip: Note that you can still get approved for a loan without a traditional job. However, you’ll need to prove you earn income through other sources, such as your side hustles, small business, child support, alimony, Social Security, or retirement accounts.
4. Loan type and amount
Not all loans are created equal. Home equity loans, for example, usually come with lower rates than personal loans because they’re backed by your house and less risky for lenders. Also, a $5,000 loan will likely have a better rate than a $100,000 loan, as it poses a smaller risk. In addition, a shorter-term loan could have a lower interest rate than one with a longer repayment schedule.
Pro tip: Explore the different types of loans at your disposal and be flexible with borrowing amounts and terms. Doing so can lead to substantial interest savings over time.
5. Down payment
Your down payment refers to the money you pay up front when you take out a loan. If you pursue a mortgage, for example, you might put down 20% of the home’s overall purchase price and finance the remaining amount. In general, a higher down payment can lead to lower interest rates because the lender won’t have to lend you as much money.
Pro tip: If possible, save for a substantial down payment before you apply for a loan. This can help you secure a lower rate and reduce the amount you spend on interest over the life loan.
6. Inflation
Inflation, which is the rate at which goods and services increase over time, often has a significant effect on interest rates. When inflation rates are high, interest rates also increase to keep consumer spending in check. Low periods of inflation, however, usually result in lower interest rates to encourage borrowing.
7. The federal funds rate
The Federal Reserve sets an interest rate that banks charge each other for short-term loans. While the federal funds rate doesn’t directly affect the interest rates you may receive, it usually plays a role in them. When the Fed raises rates, you might notice your rates are higher as well. Interest rates for loans and credit cards usually go down when the Fed reduces its funds rate.
How to Qualify for the Lowest Interest Rates
To increase your chances of low interest rates on loans, credit cards, and lines of credit, improve your credit score, pay down debt, and ensure stable employment and/or income. Also, explore different types of loans and be flexible with borrowing amounts and terms.
Additionally, take the time to do your research and prequalify with multiple lenders so you can hone in on the best rate and terms for your unique situation.
Best of luck!
by your friends at The Daily Navigator
