Taking out a personal loan can be a good option when you need funds for major expenses like home renovations, medical procedures, or consolidating high-interest debt. However, the interest rate you receive can make a big difference in how much you end up paying over the tenure of the loan.
Factors that influence personal loan interest rates
When you apply for a personal loan, the interest rate offered will depend on a variety of factors related to your financial profile. Lenders will consider these factors to determine the risk of lending money to you and set personal loan interest rates accordingly.
- Credit score
Your credit score gives lenders an indication of how reliably you have repaid debts in the past. Borrowers with higher credit scores are considered lower risk and tend to get better interest rates. Having a credit score above 750 will put you in a good position to qualify for the lowest rates. If your score is below 650, you may have a hard time finding reasonable rates.
- Income
Your income level and stability of employment also factor into lenders’ risk assessment. Higher earnings and long-term employment make you appear like a safer borrower. Providing proof of your income will help demonstrate your ability to repay the personal loan.
- Existing liabilities
Lenders will look at your current debts and expenses to gauge how much room you have in your budget to take on a new personal loan. The more financial obligations you already have like other loans, credit card balances, and high living expenses, the more lenders might find you risky. Keeping debt low can help in getting better interest rates.
How interest rates are set on personal loans
There are a few key methods lenders use to determine interest rates for personal loan applicants based on the above criteria. Understanding these can help you estimate your potential rate.
- Fixed vs floating rates
Most personal loans come with fixed interest rates that stay the same over the full tenure. Some lenders offer floating rate loans where the interest rate fluctuates based on market conditions. Floating rates come with more uncertainty but can start out lower.
- Risk-based pricing
Based on criteria like your credit score and income, lenders will assign you a risk category that matches to a rate. Lower risk borrowers get lower rates, while higher risk applicants pay more. Improving your credit and financial profile can help you qualify for better risk-based pricing.
- Base rate plus margin
Lenders start with a base rate or lowest rate they offer to the most creditworthy borrowers. Then, they add a margin percentage based on your individual risk factors. The higher risk you appear to have, the bigger margin added to the base rate.
- Competitor benchmarking
Many lenders also benchmark their rates against competitors. They try to offer similar pricing to other banks and NBFCs targeting similar customer profiles. This helps them stay competitive within the personal loan market.
Tips to get the lowest interest rate
Here are some tips mentioned below on how to secure the best rate for your financial situation.
- Maintain a high credit score
Improving your credit score should be your priority. Pay all bills on time, keep balances low, and correct any errors on your credit report. Aim for a score over 750 to access the lowest rates.
- Lower your debt-to-income ratio
Lenders look at your existing debts compared to income. Keep debt repayments under 40% of your monthly income to appear less risky. Pay down credit cards, loans, and other liabilities.
- Provide collateral if possible
Putting up an asset like property as collateral reduces lenders’ risk and can lead to better rates. But, make sure the value sufficiently covers the loan amount.
Evaluate both current rates and projected future rates based on planned improvements to your credit and debts. This will ensure you secure the optimal rate for your situation and save substantially on interest costs over the loan tenure.
