How Interest Rates on Borrowing are Calculated

Whether a personal loan is right for you depends on several important factors. Even if the loan has been advertised with a specific quoted rate, you still may end up paying something entirely different.

We take a look at how personal loan interest rates are determined and how you can find the loan that will be best for you.

Risk based pricing
Banks use two different approaches to determining interest rates. The first approach is what is known as set price lending. With these loans, every customer will be paying the exact same interest rate regardless of what their credit score might be. However, it is important to note that these loans have a much more rigid application process. Even though they do use a one-size-fits-all pricing model, if you have bad credit, you may not be able to qualify.

The other approach to lending is known as risk based pricing. In Australia, the risk based pricing model is used by most banks, though there are certainly many exceptions to this rule. As the name might imply, the risk based pricing model determines your interest rate based off of the perceived likelihood that you will pay back the loan in full and on time.

There are a few different things banks use in order to determine your specific level of risk. Your credit score is usually considered to be the most important. A good credit score indicates to banks that you have had a history of paying back your loans on time. Having a good credit score will make banks much more comfortable lending to you.

If you have a history of paying late, skipping payments, or have a limited experience using credit, then you will likely be asked to pay a higher interest rate. Additionally, some banks will look at your current employment situation when determining the risk of giving you a loan. If you are unemployed or not making very much money, they might assume you are a riskier person to lend to and this will increase your monthly interest rate.

Loan Security
Banks will also take a look at whether or not the loan is “secured.” Essentially, a loan is secured when the bank has something they will be able to take in the event that you do not pay it back. For example, if you are applying for a car loan, the bank can secure the loan by effectively saying “if you don’t pay us back, then we get to keep the car.”

Usually, secured loans still have some room for error. For example, if you are just a few days late on a single payment, it would be very unlikely that the bank would actually repossess your car. However, this leniency should not be taken for granted and you should still do what you can to pay the loan back on time.

Ultimately, if you are in the need of a personal loan, there is likely a bank in Australia that is willing to lend to you. But if you have a poor credit history or cannot secure the loan with collateral, then your monthly interest rate may be higher than others.

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