The Factors That Influence Interest Rates
An interest rate is essentially a fee for borrowing money, and it’s virtually unavoidable if an individual is looking to buy a home, car, take out student loans, or borrow any other type of funds. But while interest is sometimes unavoidable, there are lots of ways actual interest rates can fluctuate, determining if borrowers pay more or less money over time for a home, education, or vehicle. So what factors determine interest rates? In this blog post, we’ll explore the different interest rate factors and how they can drastically affect the overall purchase price.
How Are Interest Rates Determined?
There are many different factors that determine a borrower’s interest rate. Creditors and lenders use various financial factors to judge whether a borrower can pay back a loan in the determined time period. Below are some of the factors affecting interest rates:
Credit Score
A borrower’s credit score is a huge determining factor in many areas of finance. It can determine whether they are approved for any type of credit, and it can also determine the interest rates offered for all types of credit such as; credit cards, home loans, auto loans, and various other things. A credit score is generally determined by a few different factors: payment history (good and bad), total debt, length of credit history, types of accounts, and the amount of new credit the borrower currently has.
Employment Status
Another important factor determining a borrower’s interest rate is employment status. If the borrower is a full-time worker who earns enough money to reliably pay off a loan within a set amount of time, they will likely receive a better interest rate as they are seen as less of a risk. However, those who are self-employed, working part-time, or whose salary largely depends on bonuses may need to prove they can receive a regular amount of income that would enable them to pay back their loans. The higher the identified risk the higher the interest rate offered.
Debt-to-Income Ratio
To lenders, a loan applicant’s debt-to-income ratio is an important indicator of dependability and level of risk. A debt-to-income ratio measures a lender’s monthly debt payments divided by their gross monthly income. If a borrower has monthly debt payments for an auto loan, student loan, and other loans that make up more than 30% of their income, a lender could worry about their ability to make loan payments on time. If a borrower has a low debt-to-income ratio, they are poised at a lower risk and may receive better interest rates.
Down Payment Amount
Paying a significant down payment can help lower interest rates because lenders will see the borrower as less of a risk if they have already invested a good amount of money in the asset. With mortgage loans, for example, experts usually recommend paying 20% of the purchase price to ensure borrowers pay less interest over time. Anything lower than that and the lender might be concerned of the borrower’s ability to pay, assigning a higher interest rate which means lenders pay more over time.
How Does the Government Determine Interest Rates?
Another big determining factor of interest rates has to do with the United States Federal Reserve (the Fed). The Fed periodically makes announcements about the federal funds rates, which determines the interest rates banks and lenders can put on their loans. The rate can fluctuate depending on inflation and monetary policy. When the economy is booming, the Fed might raise interest rates to pump the brakes and avoid too much inflation. But if the economy is experiencing a downturn, the Fed might lower interest rates to encourage consumers to take out loans, which can stimulate the economy.
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