Personal loans can be a smart alternative to credit cards, often offering lower interest rates and a chance to build or strengthen your credit. Your own bank or credit union may have competitive options, but shopping around is key to getting the best rate.
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Before you borrow, it helps to understand the biggest factors that determine what rate you’ll pay. Here are seven key things you need to know about personal loans.
Interest rates on personal loans are determined by larger economic forces and the individual borrower’s credit history and score. Some of the factors that have the biggest impact are:
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Economic environment: Federal Reserve policy, inflation and overall credit market conditions drive rates up and down.
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Lender’s risk tolerance: Rates also reflect the lender’s own costs, operational overhead and their risk tolerance for potential loss if a borrower defaults.
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Borrower-specific factors: Lenders evaluate individual borrowers’ credit scores, debt-to-income (DTI) ratio employment status and repayment history.
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Of all these factors, credit score plays a big role in the rate you’ll be offered, as it’s the lender’s way of understanding their level of risk in loaning you money.
Higher credit scores (670 and up) may qualify for lower rates, while those with scores in the fair (580 to 669) to poor (below 580) credit tiers may see significantly higher interest rates.
The loan length determines how quickly or slowly you’ll repay the money you’ve borrowed and will also affect how much interest you pay. Shorter-term loans (24 to 36 months) tend to come with lower rates as a kind of incentive for the likely lower risk the lender is taking. Thus, longer-term loans (60 to 84 months) tend to come with higher interest, since there’s a greater likelihood of missed or defaulted payments the longer you have to pay it back.
While a longer-term loan often results in a lower monthly payment, over the life of that loan you’re paying a lot more in interest.
For example: A $10,000 loan at 10% over three years costs around $1,600 in interest. The same loan at 12% over seven years will cost you around $4,800, additionally — a significant amount of money.
There are two main ways that interest can be applied to your loan, either fixed-rate or variable-rate loans.
