Loan Interest Rates: How Lenders Arrive at Rates  

Loan Interest Rates: How Lenders Arrive at Rates  

Written by Lisa Rennie
Fact-checked by Caitlin Wood
Last Updated October 12, 2022

If you’re thinking about applying for a loan, one of the first questions you’ll likely have when applying is what your interest rate will be. After all, your interest rate will have a direct effect on how expensive or affordable your loan will be. The higher the rate, the more money you’ll have to dish out, which is why a lower rate is always ideal.

How Do Lenders Determine The Interest Rates They Charge You? 

Lenders charge interest on their loans as a way to cover costs and make a profit. That said, they don’t arbitrarily pick a rate to charge their clients. There are several factors that play a role in how lenders come up with the interest rates they charge their clients, including the following:

Bank Of Canada’s Interest Rate 

The policy rate set by the Bank of Canada affects the prime rate that lenders charge. This is because the policy rate is the rate that lenders pay to borrow money. 

When banks have to pay more to borrow, they charge higher rates to borrowers. But if they pay less, they’ll pass on these savings to borrowers through lower rates.  

Your Credit Health 

Your credit score plays a direct role in the interest rate your lender offers you. The higher your credit score, the lower the interest rate the lender will charge, and vice versa. That’s because your credit rating provides lenders with a picture of your creditworthiness. 

If your score is high, that typically means you’ve been responsible with your debt and can be trusted to make regular payments towards paying off a loan. 

Type Of Loan 

The interest rate you’re charged can vary greatly depending on the type of loan you’re looking to take out. For instance, the interest rate on a mortgage is usually much less than the rate for an unsecured personal loan. Generally speaking, lenders charge higher rates on riskier loans. 

Since a mortgage is secured by a valuable asset, the loan is not as risky for the lender. But extending a large sum of money on an unsecured personal loan can be much riskier for the lender, who will offset this risk with a higher interest rate.  

Types Of Interest Rates 

The rate you’re charged will also vary based on whether you take out a variable-rate or fixed-rate loan. Generally speaking, variable rates tend to be lower than fixed rates, partly because they’re riskier for borrowers. 

If you choose a variable-rate loan and the rate increases in the near future, your loan cost will also increase. Due to this risk, lenders charge lower rates upfront for variable loans.

Why Do Short-Term Loans Have Lower Rates Than Long-Term Loans

Lenders determine the rate they charge based on risk. The higher the risk, the higher the interest rate they will offer, generally speaking. The opposite is also true: a lower-risk scenario will typically mean a lower interest rate.  

Longer-term loans are considered riskier for lenders because the borrower has more time to default on the loan. Moreover, the lender’s money is tied up for a longer period of time, which means they can’t use it for other investments. 

Short-term loans, on the other hand, need to be repaid much sooner. There’s less risk for the lender because the borrower doesn’t have as much time to miss payments. Plus, the lender’s funds are not tied up for so long, and the funds become available much sooner to be reinvested. 

How Does The Bank Of Canada Affect The Interest Rate You’re Charged? 

As mentioned before, the policy rate set by the Bank of Canada can affect the prime rate that lenders charge. When the policy rate increases, the cost of borrowing for banks becomes more expensive. As a result, banks will respond by increasing their prime rates to cover the increased cost of borrowing. Similarly, when the policy rate decreases, banks will lower their prime rates. 

Changes in the prime rate generally affect the mortgage rates you’re offered in Canada, for both fixed and variable mortgages. 

What Is The Benchmark Rate?

The benchmark rate is a rate big banks and conventional lenders across the country use as a guide to qualify borrowers for a mortgage. 

How Do Alternative Lenders Set Their Interest Rates?

Alternative lenders use risk to set their rates. Unlike banks, however, alternative lenders are not regulated in the same manner. That means they don’t have to follow all of the same rules that banks do. As such, many of them often set their own rates as they see fit and the rate that they offer will typically be directly related to the risk level of the deal.

If, for instance, they are lending money to a low-risk borrower, the interest rate they offer will typically be lower. On the other hand, a borrower who is considered high-risk will likely be offered a higher interest rate.

What Factor Do Alternative Lenders Use To Determine Risk?

There are a few important factors that alternative lenders look at when determining risk in lending:

Credit History 

Your credit history is the most important metric lenders use to gauge your ability to repay the loan. A history of timely loan payments typically means you’re more likely to make future loan payments on time. In this case, you’d be considered a low-risk borrower and will have a better chance of securing a loan at a more affordable interest rate.

Income

You’ll need a sufficient and reliable income to cover your loan payments, as well as stable employment. Your lender will want to see documents to support your earnings, such as pay stubs and tax receipts. 

Debt-to-Income (DTI) Ratio 

Not only should your income be sufficient, but it should also be more than enough to cover all your debts with plenty left over. Your debt-to-income ratio is a measure of your gross monthly income relative to your monthly debt and should be no more than 35% to 43%. Anything higher could mean that you’ll have trouble covering all your bill payments month over month.

Collateral

If you’re applying for a secured loan, you’ll need to back the loan with a valuable asset, like your house or car. Your lender will want to assess your collateral to make sure its current value is enough to cover any losses the lender may incur if you default on your loan. 

Loan Term

A longer loan term gives you more time to miss payments along the way, which may be riskier for the lender. While your current financial situation might be strong, anything can happen over the loan term that could affect your ability to repay your loan in the future. 

Alternative Lenders Help Borrowers Enter The Market

Some borrowers have unfavourable financial situations that make them ineligible to qualify for a loan or mortgage with a bank, for example:

  • Low credit scores 
  • Small down payment
  • Too much debt 
  • Past bankruptcy or consumer proposal 

Alternative lenders typically offer loan products that are easier to qualify for, in exchange for a higher interest rate. Ultimately, this allows borrowers to enter the market when they cannot get approved by a big bank. 

Interest Rate FAQs

What is the maximum interest rate a lender can charge in Canada?

Under Section 347 of the Criminal Code of Canada, lenders are not allowed to charge an annualized interest in excess of 60%. Anything above this level is considered a criminal offence. Payday lenders, however, are exempt from this rule.

Why do lenders charge different interest rates?

Interest rates are not usually much different from one lender to the next. However, the actual rate and loan fees can vary significantly.  Lenders are out to make a profit and have to consider all the overhead costs they need to cover. That’s why it’s important to compare and shop around when you need a loan to make sure you get the best deal.

How does inflation affect the benchmark rate? 

When the rates increase, it’s usually due in part because the Bank of Canada wants consumers to spend less in an effort to reduce inflation if it starts to rise. The ideal inflation mark is around 2%, which is what the central bank aims for. On the contrary, when the rates decrease, it’s typically because the Bank of Canada wants to stimulate spending and make it more affordable to borrow money, which will help increase inflation to the 2% mark.

Why do lenders charge interest rates? 

In order for banks and conventional lenders to turn a profit, they need to charge an interest rate. The rate they charge is affected by numerous factors including how much it costs banks and lenders to obtain the funds that are loaned out to borrowers.

How do alternative lenders approve mortgage applications?

Alternative lenders will look at your creditworthiness, your debt-to-income ratio, your income, and in general your ability to afford your payments. Keep in mind that while alternative lenders will work with poor credit borrowers, they do charge higher interest rates.  

Final Thoughts

The Bank of Canada certainly has a major influence on rates, which in turn influences the rates that banks and lenders charge.

But your perceived risk also plays a role in the rate you’re offered. Factors such as your credit scores, income, and debt-to-income ratio come into play when lenders determine what type of interest rate to offer you. While the central bank has much to do with these rates, you can increase your chances of scoring the lowest rate by ensuring that your financial health and history are as strong.


Rating of 2/5 based on 7 votes.

Lisa has been working as a personal finance writer for more than a decade, creating unique content that helps to educate Canadian consumers in the realms of real estate, mortgages, investing and financial health. For years, she held her real estate license in Toronto, Ontario before giving it up to pursue writing within this realm and related niches. Lisa is very serious about smart money management and helping others do the same.

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