What factors affect personal loan interest rates?

Understand the process and factors that affect interest rates before you apply for a personal loan. (iStock)

A personal loan is a flexible financing tool you can use to purchase a car, consolidate debt, complete a home repair, or pay for school. And if your credit score is good, you could qualify for as much as $100,000.

If you’re considering getting a personal loan, the first thing to do is to visit an online marketplace like Credible to compare loan options from multiple lenders at once, saving you time. Rates can range from 3.49 percent to 35.99 percent, and you may wonder why there’s such a discrepancy. Lenders review several criteria when determining the rate to offer you.

1. Credit score

Your credit score is a number assigned by reporting agencies such as Equifax, Experian and TransUnion, and it helps a lender assess risk. Your score will be based on your outstanding balances, repayment record, credit mix, and account length. Credit scores range between 300 and 850, with a higher score being better.

Another thing that affects your credit score is how often lenders pull your credit history. To prequalify you, lenders will pull a soft inquiry, which won’t impact your credit score. When you apply for credit, however, a lender does a hard inquiry. Hard inquiries stay on your report for two years, and they account for around 10 percent of your credit score. The fewer hard inquiries you have, the better. If you’re simply checking rates, be sure to use a site like Credible that uses soft inquiries to provide prequalified rates from multiple lenders without affecting your credit score.


2. Debt-to-income ratio

Another determining factor is the amount of debt you have compared to your gross income, which is your debt-to-income ratio. Debt includes loans, mortgages, leases, and credit cards, but not monthly expenses, such as utilities or groceries.

If your gross income is $5,000 a month, and your debts total $2,100, your debt-to-income ratio is 42 percent. According to the Consumer Financial Protection Bureau, mortgage lenders look for debt-to-income ratios at or below 43 percent. For personal loans, a lender’s standards may vary. The lower your ratio, the better your rates will most likely be.


3. Employment history and income

Lenders will also want to know how you plan to pay back the loan, and they typically look at your employment history. Many lenders review the past 24 months of employment history, while some may go back farther. They are looking for a solid track record of employment. For example, someone who has been in the same job for two years will look like a lower risk than someone who is fresh in the job market.

Your income can also impact your rate. Some lenders set low or even no minimum income requirements, but borrowers with higher incomes are usually offered lower interest rates. Your loan payment will impact your monthly budget. Credible’s online calculator can help you determine the monthly payment to make sure you can afford it.


4. Loan term and amount

The length of the loan will also impact your interest rate. Personal loans can range from one to seven years. Longer-term loans usually have higher rates than a shorter loan.

The amount of money you want to borrow may also impact the interest rate. Lenders take on a higher risk by providing a larger loan amount, and they may charge a higher interest rate, as a result. You can easily find out how the loan amount can impact the rate by visiting Credible, where you can view rates for loan amounts ranging from $1,000 to $100,000.


5. Collateral

Most personal loans are unsecured. However, if you have bad credit or short employment history, you may be able to reduce your rate by offering a form of collateral. If the loan purpose is to purchase a car, for example, you can use the car to secure the loan. If you have other valuables, such as a CD, lenders may use that collateral to reduce your interest rate. If a borrower doesn’t pay, the lenders will take the collateral to cover their costs, limiting their risk.

By knowing what a lender considers before approving a personal loan, you take steps to improve your situation before you apply to get the lowest interest rate.

You may also improve your chances of getting approved quickly. A personalized loan offer can help you achieve your financial goals and stay on track for the future as long as you use it responsibly.