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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.
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:
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 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.
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.
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.
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.
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.
The benchmark rate is a rate big banks and conventional lenders across the country use as a guide to qualify borrowers for a mortgage.
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.
There are a few important factors that alternative lenders look at when determining risk in lending:
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.
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.
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.
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.
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.
Some borrowers have unfavourable financial situations that make them ineligible to qualify for a loan or mortgage with a bank, for example:
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.
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.
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