An interest rate is the extra amount of money that a borrower will have to pay to the lender, on top of the sum that they actually borrowed. It’s how the lender profits from lending the money to the borrower. Most importantly, it’s how borrowers choose whether the loan terms are acceptable or unacceptable. While there are other terms in question like the loan term duration, origination fee, loan requirements, etc., it goes without saying that the interest rate is the single most important item on this list. So, how do banks set interest rates on your loans? Let’s find out!

1. Credit scoring system

The APR is often determined by the credit score of the borrower. The way this works is fairly simple. Based on five factors (payment history, amounts owed, credit history length, credit history mix and new credit) the lender determines the creditworthiness of the borrower. This way, the lender can figure out what kind of risk they’re exposing themselves to. For those with lower credit scores (riskier borrowers), the APR is substantially higher. This way, the lender is risking more but also getting more. This simple system relies on both soft and hard credit inquiries in order to provide additional security to the lender.

2. The funding cost to the bank

Another thing worth focusing on is the funding cost to the bank. Keep in mind that there’s a certain bureaucratic process that needs to take place in order for the loan to be produced. Now, some lenders charge this through the initial expenses, deposits or an origination fee. Others merely include this in the interest rate. Keep in mind that the funding also has an operating cost. Processing, wages to people who monitor and handle the administrative aspect of the process and even occupancy expenses. Overall, the bank, as a business, has operational expenses of its own that need to be covered.

3. Unsecured loans

The most common type of loans on the market are unsecured loans. Instead of looking for collateral, these lenders make a decision whether to issue a loan based on one’s credit score, as well as some other factors. The majority of lenders pay special attention to things like credit history, which is why recently missed credit payments or recent bankruptcies may disqualify you (or result in horrible loan terms). Other than credit score, the platform may also insist on seeing the borrower’s income-to-debt ratio or just look for proof of income.

4. The collateral

One of the most popular types of loans is the so-called secured loans. Secured loans are a lending option that uses collateral as a form of a warranty. Because the borrower is offering an actual asset, the lending platform/direct lender can offer them better terms. This is why secured loans usually come with a substantially lower APR and much better loan terms than their unsecured alternatives. Unsecured loans, therefore, mostly rely on the credit score. In other words, someone with a tad lower credit score and an asset in their possession should probably look for a secured loan.

5. Payday loans

Payday loans are a special loan type with the shortest possible loan duration term and an incredibly high-interest rate. This type of loan is only used in moments of an emergency. The way this works is that the borrower takes a small amount of cash and returns the money as soon as they receive their next salary. This type of loan doesn’t require a credit score check (not even a soft credit inquiry). However, since it’s risky and the figure is usually minuscule, the APR on these loans can go up to 300%-400%. In other words, these loans are only used in moments of the utmost necessity.

6. Special conditions

Now that we’ve covered all the major loan types, it’s important that we mention that there are some special conditions regarding the loan that you’re taking. For instance, when you manage to find a co-signer, you may get a much better APR for your loan, even if your own credit score is not that impressive. Joint loans are another situation where your own credit score won’t restrict you as much. The key thing is that the other person has a decent credit score in order to provide the lender/bank with a higher level of security.

In conclusion

While there are some norms and government proscriptions on the maximum APR, the majority of lenders base their interest rate based on the risk that they’re exposed to when lending the money. The key thing to bear in mind is that different loan types have different factors that affect the interest rates in a different way. Secured and unsecured loans fundamentally change the way in which lenders operate. The same goes for joint loans and co-signers. It is important to explore all your options and look for the option that gives you the best possible loan terms.