Personal loans can be a better way to borrow for many reasons. One of those reasons is that most personal loans come with fixed interest rates. But how high are those rates? The personal loan interest rates lenders offer you depend on several factors:
- The overall economy. Many lenders start with the Prime Rate and adjust from there.
- Your credit rating. This is the most important factor because personal loans are only secured by your promise to repay.
- Your debt-to-income ratio. This indicates how affordable the loan is with your income and debts.
- The loan amount. Very small and very large personal loans may carry higher interest rates.
- The loan term. Loans with longer fixed-rate terms are riskier to lenders, so their interest rates are higher.
This article breaks down these factors and shows you how to get the lowest personal loan interest rates for which you qualify.
How the Economy Affects Your Interest Rate
The first factor that affects your interest rate is the economy. While you don't control the economy, you should understand its impact a little so that you can make smart borrowing decisions. When interest rates are rising, for example, replacing variable rate credit card debt with a fixed-rate personal loan could be a smart decision. So it pays to pay attention.
Most personal loan interest rates are based on the Prime Rate. The Prime Rate is the short-term interest rate that banks charge their best customers. You can find the Prime Rate online every day. As of this writing, it's 4.75%. The best personal loan interest rates are currently about 6%, an increase of 1.25% over the Prime Rate.
If you are a top-drawer personal loan applicant, look for rates slightly above the published current Prime Rate.
What causes the Prime Rate to change? Economic conditions. When the economy is weak and investors are uncertain, they tend to pull money from the stock market and place it in safe investments like government-guaranteed bonds (Treasuries). And nervous investors become willing to accept lower interest rates in return for safety. That causes interest rates for other loans to fall as well. The opposite is also true - when the economy is booming, prices increase, inflation becomes a concern, and interest rates rise.
Personal Loan Credit Grades: How Do You Stack Up?
The biggest influence on your personal loan interest rate is your credit grade. First, there is no one system of credit grading for personal loans. However, the American Institute for Economic Research (AIRC) has published a scale that mimics that of many lenders and does provide a reasonable estimate. Here are the credit grades by FICO score:
- 760 and higher: A+
- 700: A
- 660: B
- 620: C
- 580: D
- Under 580: F
Note that many personal loan providers do not make loans to applicants with FICO scores under 600. And interest rates within grades of A+ to C range from about 6% to 36%. The other factor that determines your rate within your credit grade is your debt-to-income ratio, or DTI.
Personal Loan Credit Grades: Debts Matter
Personal loan providers consider your debt-to-income (DTI) ratios when offering you an interest rate, because their risk increases as the loan's affordability decreases. DTI is equal to your total monthly debt payments plus your housing costs, divided by your gross (before tax) income. Living costs like utilities and food don't count.
So if your gross monthly income is $5,000 your rent is $1,000 and you have a $600 / month car payment and $400 a month in credit card payments, your DTI is $2,000 / $5,000. That's 40%. If you wanted a personal loan with a payment of $500, your DTI would be 50% ($2,500 / $5,000).
What Is a Good DTI?
Within each credit scoring tier, lenders examine your DTI. There are several levels of DTI.
- 28% and below is excellent. You easily afford your debts and should have no problem repaying a personal loan.
- 29% to 36% is also very very good. You're considered low-risk with this DTI.
- 36% to 43% is good and you can easily get a personal loan if your credit score is good-to-excellent.
- 44% to 50% is borderline. If your credit score is very high, lenders will consider you, but you'll pay more.
- Over 50% is considered high risk. Unless your credit score is excellent, you'll have a difficult time obtaining personal loan approval.
Personal loan providers examine both your DTI, which represents your ability to repay the loan, and your FICO score, which indicates your willingness to repay your debts. Note that you may be able to lower your DTI by consolidating high-interest debt with a personal loan.
With fixed-rate loans, longer terms equal more risk to lenders. That's because while your lender is locked into the rate it gives you, the rest of the world is not. And if inflation becomes a concern, investors will demand higher interest rates.
A bank, for instance, might pay depositors 1% for the use of their money. After calculating the costs of running its business, and the costs of expected defaults, the bank may choose to lend unsecured money at 10%. But if inflation causes depositors to demand 3%, the business model is upset. The bank might lose money. You don't want to be charging 10% in a 12% world.
A look at online personal loan rates for various terms shows that interest rates tend to increase at about .25% for every 12 months you extend a term. So a 6% loan for one year becomes a 6.25% loan for two years, and so on. But every lender has its own specific pricing model, and you'll want to compare a few offers to find the best combination of rate and term for you.
Personal Loans: Three Moving Parts
Personal loans are installment loans. This means you receive a lump sum when your loan funds, and you pay it back in monthly installments. They normally come with fixed interest rates and payments. The advantage of this setup is that you know exactly what your payment is every month and exactly when you will pay off your loan. That's very good for budgeting and many experts consider them a more responsible way to borrow than a credit card.
Three elements of a personal loan determine your monthly payment. They are:
- Interest rate
- Term (number of years you take to repay the balance)
- Loan amount
You can reduce your monthly payment by choosing a loan with a longer term. However, your total interest cost will be higher when you extend your repayment.
Comparing Personal Loan Offers
When you get an offer from a personal lender, examine the fees plus the interest charges. That's not actually hard.
- Multiply the monthly payment by the months in your term to get the total you'll pay over the life of the loan.
- Subtract the amount you are borrowing.
- Add any origination, setup, maintenance or other charges.
Then just choose the loan with the lowest overall costs.
Another way to compare that works better for revolving personal loans or those with variable interest rates is to look at the Annual Percentage Rate, or APR. In general, the loan with the lowest APR is also the one with the lowest combined upfront costs and interest charges.
Personal Loan vs Credit Cards: Interest Rates
Credit cards, like personal loans, are also unsecured. The card issuer relies on your promise to repay. But credit cards have variable interest rates that can change. They are open-ended, which means you can use them, make payments, and reuse them. In fact, you may never have to pay them off. This can be very convenience, but also very expensive.
According to the Federal Reserve, the average credit card interest rate (as of this writing) was 16.97%. While the average personal loan interest rate for a 24-month account was 10.07%.
Does this mean that personal loan interest rates are always 7% lower than credit card interest rates? Not necessarily. Credit cards often come with promotional deals offering special low rates, rewards and other goodies to get you to sign up. But there is a reason they do this - statistics show that they will more than make up the cost of those promotions once you are using the account and start paying interest.
So, while credit cards might be a great way to pay for purchases, they can be a terrible way to finance purchases. They make it very easy to carry balances for years and even decades. They make it easy to overspend. And yes, their interest rates are higher than those of personal loans.
How to lower personal loan costs
Of course, no one wants to pay any more than necessary for a personal loan. And there are steps you can take to minimize your costs.
- Borrow for the shortest term in which you can afford the payments. Not only do you get a lower interest rate, you also pay that rate over less time. The chart below for a $5,000 loan illustrates this.
- Improve your credit score. First, make sure it's accurate and that you won't be penalized by inaccurate information. You can get one free credit report every 12 months from each of the three major credit reporting agencies -- Experian, TransUnion, and Equifax -- by going to AnnualCreditReport.com. Correct anything that might cause you to pay a higher interest rate.
- Consider putting up collateral. By turning an unsecured personal loan into a secured personal loan, you're reducing the lender's risk. And less risk means a lower rate.
- Similarly, you may be able to get a better rate by bringing in a co-signer or co-borrower. If that person has a better credit profile than you do, lenders may be willing to offer you a better interest rate.
- Last, and perhaps most important, compare offers from several personal loan providers. Interest rates and fees vary widely for all credit grades, and the more offers you see, the better your chance of getting a good deal -- no matter what credit grade you find yourself in.