Signature Loans: What Determines Your Interest Rate?

As anyone who borrows money knows, lenders like to reduce the risk that they won't get their money back by asking for collateral to "secure" loans. Loans can be secured by collateral like real estate, vehicles or other personal property. Yet when it comes to signature loans, which are based only on an applicant's income and credit scores, lenders may be left without anything of value if borrowers default. Therefore, interest rates are higher… but how do lenders actually calculate their rates? To determine the rate they're willing to offer, lenders consider your credit score, the amount borrowed, how long it will take to pay back the loan, and possibly your other business with the lending institution.

Your Credit Score

Because a signature loan is unsecured, the lender pays close attention to your financial behavior. It pulls a credit report, which compiles your history of borrowing and repayment for credit cards, mortgages, lines of credit and other secured or unsecured loans. A higher credit score is supposed to predict a lower risk that you'll default on your loan. Some more conservative banks may only offer signature loans to borrowers with very high credit scores. This good news is that a high credit score suggests a lower risk, and this points to a lower interest rate for you.

The Amount Borrowed

Typical amounts borrowed with signature loans may range anywhere from $3,000 to $35,000, and the amount you borrow affects the interest rate you receive. Generally, the lower the amount borrowed, the higher the interest rate charged. This is because statistically, the likelihood of default is greater with lower amounts, so the lender is at greater risk of losing its money. In addition, the income generated by a larger loan goes further in offsetting the costs of underwriting and funding the loan – so the interest rate can be lower. For example, as of this writing, with one national lender, a borrower in California will pay 8.26 percent interest with a $3,000 unsecured loan for 36 months. Yet if the amount borrowed increases to $10,000 for 36 months, the rate drops to 6.258 percent.

Loan Term

Unlike unsecured revolving credit products such as credit cards or personal credit lines, signature loans usually come with fixed repayment terms, often in the one-to-five year range. Generally, choosing a longer term means paying a higher interest rate. This is because as time goes by, default risk (the odds that the borrower will fail to make payments) and interest rate risk (the odds that market interest rates will rise) increase. For example, a borrower at a large California institution considering a $10,000 loan may pay 6.258 percent with a three-year term or 6.254 percent with a one year term, a slightly higher rate to reflect the increased risk.

Other Business with the Lender

Some banks offer a small interest rate reduction for signature loans to borrowers who do other business, like savings and checking, with them. Sometimes the rate deduction requires borrowers to set up an automatic payment from a bank account with the lender to make the regularly scheduled loan payments.

Though they may have higher interest rates than secured loans, signature loans can be a good solution for borrowers who have strong credit scores and don't have or wish to risk collateral. To get the best interest rate, have lenders compete for your business by getting multiple online loan quotes.

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