How Lenders Set Their Interest Rates (and How to Beat Them)

How Lenders Set Their Interest Rates (and How to Beat Them)

Written by Bryan Daly
Fact-checked by Caitlin Wood
Last Updated August 26, 2022

Are you considering applying for a mortgage, car loan or another type of credit product? Are you worried that the product’s high-interest rate will damage your finances and ultimately, your credit health? When it comes to loans, interest rates are a factor that many borrowers forget to take into account. They assume they can afford their loan payments as they stand, but fail to factor in the extra money that their interest rate will end up costing them.

Wondering how to deal with rising interest rates in Canada? Check this out.  

Because of the debt they can lead to, many borrowers are now wondering how lenders go about setting their interest rates. What are the factors that lenders consider when determining which rates they’ll give to borrowers with good credit, bad credit, or no credit at all? What about when it comes to the type of product they’re applying for? And, of course, is there any way of avoiding high-interest rates to make a loan more affordable?

What Are Interest Rates and Why Do Lenders Charge Them?

Lenders, also often referred to as creditors, are taking a risk when they let you borrow money from them. If you, as the borrower, don’t pay them back in full, they could potentially lose a lot of money. Even if you did return the full sum of the loan, the lender would make no profit for their business without interest. So, they need to charge an extra percentage of money in addition to the principal amount you borrowed. In other words, the interest rate refers to the price of borrowing.

Read this to learn how you can get the best interest rate for your line of credit.

How Lenders Set Their Interest Rates

Determining how lenders set their interest rates isn’t always a simple explanation. Mainstream or “prime” lenders, such as banks and credit unions usually set their rates according to the Bank of Canada’s benchmark rate, which is also known as “prime rate”. Alternative and private (subprime) lenders, on the other hand, often deal out varying interest rates in correspondence to a potential borrower’s financial and credit profiles. If a borrower doesn’t pay them back, these subprime lenders would have a harder time recovering from their loss than most prime lenders. Therefore, they’re likely to base their rates on a borrower’s “creditworthiness”, meaning the level of risk that said borrower will default on their loan.

Defaulting” refers to when a borrower doesn’t honor their loan agreement in some way, whether it’s by making a late payment, a short payment, or missing one entirely. The same goes for straying from the payment schedule and not paying their lender back by the date that was agreed upon.

For more information about how lenders arrive at their interest rates, click here.

Elements That Lenders Examine

All lenders want to be sure of one thing; that you’ll be able to pay them back on time and in full. So, when you apply for a credit product, one of the first things they’ll examine will be the health of your credit and finances. During that examination, they’ll be on the lookout for any signs that you may, one day, default on your payments. Some elements that they’ll look at include, but aren’t limited to your:

Look here to find out how the length of your credit history affects your credit score.

Secured vs. Unsecured Credit

Keep in mind that the way your lender judges your creditworthiness will also depend on the type of product and the amount of credit you’re applying for. Strictly speaking, there are two kinds of credit debt you can take on, known as “secured” and “unsecured”.


Your loan is weighed against one of your assets, such as your house, car, or other valuable property. This is known as “collateral” and is commonly seen with more expensive, riskier products like mortgages, auto loans, and large personal loans. Collateral is an incentive that you offer your lender to raise your creditworthiness. If and when you can’t initially get approved based on your finances and credit alone, offering collateral will certainly improve your chances. If you default, your lender can foreclose on or repossess the property. They’ll then have something to sell to recuperate part of (or all of) their loss in the event that you default. Result: Because you’re offering this incentive, your subprime lender may grant you a lower interest rate.

How is secured debt treated during a bankruptcy? Find out here.


More basic products, such as credit cards and lines of credit are often referred to as “unsecured” because they don’t involve collateral. Result: Since no assets are offered, depending on the type and amount of credit you’re requesting, your interest rate will be calculated based on the health of your finances and credit.  

For a more detailed explanation of secured and unsecured credit, look here.

Why Lenders Examine Your Finances and Credit

When it comes to lenders examining your finances to determine your interest rate, the reasons are obvious. Firstly, they’ll want to make sure that you’re steadily employed and making a large enough monthly income to cover your future payments, including the interest fees, penalties, etc.

However, just because you have a healthy looking bank account, doesn’t necessarily mean you’ll be responsible with the credit you’ll be given. After all, even people with good incomes and high net worths have trouble remembering to pay their credit card bills. That’s why your credit report, credit score, and credit history will become extremely important. All these credit-related elements showcase your willingness to pay them back in full and on time.

For a better understanding of your credit score and credit rating, read this.  

So, before calculating your interest rate, your lender will pull a copy of your credit report from Equifax or TransUnion (Canada’s two main credit reporting agencies). By doing so, they may see:

  • Good credit: If your lender sees a history of good credit account payments and a solid credit score (660-900), they’ll consider you a less risky borrower. Your chances of approval will then increase, earning you a lower interest rate.
  • Bad credit: If they see a record of late or missed payments, or any other delinquent activity resulting in a lower credit score (300-659), you’ll be deemed more risky. As a result, your interest rate will go up.
  • No credit: If you’ve never used a credit product and therefore have no credit history, your rate will more likely depend on your income and the amount of credit you’re requesting. If it’s a small loan, for example, your lender might see your income and give you a reasonable rate despite your lack of credit. However, no-credit consumers applying mortgages or car loans might have slimmer chances of approval simply because their lender has no payment history to examine. If they are approved, their rate might be higher than someone with a good history of responsible credit usage and/or collateral.

When a lender pulls your credit, it’s listed as an “inquiry”. Click here to know more.

Are There Ways Of Beating High-Interest Rates?

As we mentioned, the healthier your credit and finances are, the less risky you’ll be considered. Unfortunately, if you’re not making a good income and you already have poor credit or none at all, your interest rate will generally be higher upon approval, depending on your lender’s requirements.

However, there are ways of improving your finances and credit so that you’ll be approved for a good interest rate in the near future.

Paying Your Bills On Time And In Full

Missing or making late payments on your active credit accounts (credit cards, etc.) can do significant damage to your credit score. The more bills you pay responsibly, the higher your score will rise and the lower your interest rate will be.

Experienced a late payment? Here’s how you can rebuild your credit.

Improve Your Credit  

If your credit is already poor, there are measures you can take to improve it (besides paying your bills properly), including but not limited to:

  • Requesting a copy of your own credit report from both Equifax and TransUnion. By doing this, you’ll know where your credit health stands and where you can start improving it. Click here to find out how you can obtain a free yearly copy of your credit report.  
  • Disputing errors on your credit report. Even small errors in your personal information or mistakes reported by other lenders can hurt your score until you fix them.
  • Avoiding applying for too much new credit within a short period of time (when a lender performs a “hard inquiry” when requesting your credit report, your credit score drops a few points). By examining your report, your lender can also see that you’ve applied and been denied multiple times, which may act as a warning sign that you’re a risk client to take on.

Increase Your Income  

While this is easier said than done, remember that your lender wants to know, first and foremost, that you’ll pay them back by the designated due date. Try asking for a pay raise at your current workplace, even get a second job if necessary. This way, you’ll be showing your lender that you’ll keep up with your future payments. In addition, you’ll actively be making your loan more affordable because of your lower interest rate.

Look Around At Different Lenders

If your financial health is good but your current lender won’t offer you a reasonable interest rate, shop around for a better lending institution. Small private lenders, for example, don’t make as much capital as mainstream lenders, so they need to charge higher rates. In this case, a more well-established lender might be a better choice.

Shopping for low-interest rates? Consider this.


Not all interest rates are set in stone. While some prime lenders, such as banks, have regulations that prevent them from changing their rates, some subprime lenders are open to a bit of negotiation. Indicate that you are and will continue to be a valuable, responsible client. Who knows? They may offer you a lower rate for your effort. If not, at least you tried.

Find a Responsible Cosigner

Using the same principle as offering collateral, finding someone to cosign your credit product application might earn you a better rate when your own financial health doesn’t. Make sure that person has been and will continue to be a responsible borrower and that they know what they’re agreeing to. If you default, they’ll be held accountable for your payments.

A Lower Rate is in Your Best “Interest”

Finding the lowest possible interest rates for your credit products isn’t always an easy task. However, it can be done, as long as you put forth the effort. Remember, getting approved for a lower rate can save you hundreds, even thousands of dollars a year, so it will work in your favor to try.      

Rating of 5/5 based on 3 votes.

Bryan is a graduate of Dawson College and Concordia University. He has been writing for Loans Canada for five years, covering all things related to personal finance, and aims to pursue the craft of professional writing for many years to come. In his spare time, he maintains a passion for editing, writing screenplays, staying fit, and travelling the world in search of the coolest sights our planet has to offer.

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