How Interest Rates Are Calculated on Installment Loans

When you’re looking at taking out an installment loan, it’s important to understand interest rates and how they will impact the overall amount of money you pay back to your lender. Understanding how installment loan interest rates are calculated can save you money and help you choose the best loan option. Let’s break down the numerous factors that influence interest rates and how they’re calculated.

What are interest rates?

When taking out a loan, it’s important to realize that the total amount of money you’ll end up paying isn’t quite the same as the flat price of the loan. That’s because of interest rates: the cost of borrowing money. Installment loan interest rates are expressed as a percentage of the loan amount, and can be fixed or variable.

A fixed interest rate does not change throughout your loan payment. For example, say you take out a one-year loan for $5,000 with a fixed interest rate of 5%. Monthly payments will come to $428.04, and overall, you’ll be paying $136.45 in interest.
Variable interest rates get a bit more complicated. They exist in relation to a reference index that reflects the market, and that rate is applied to your loan (usually plus a margin from your lender). This index is often the country’s prime rate plus a percentage margin. Your lender will also set a time interval, say three months, after which the variable rate will be updated to match that prime rate if it has shifted. Why take the risk? Variable-rate loans are often cheaper than fixed rates, so long as the market isn’t in a state of rapid change.

Factors that influence installment loan interest rates

How do lenders decide how much interest to charge you? Let’s break down the top five factors that have a major impact on installment loan interest rates.

1. Credit Score

A high credit score generally shows potential lenders that you’re reliable and will pay back your debt in a timely manner. That means you’re a low-risk client, and a lender might offer you a lower interest rate. 

If your credit score isn’t particularly high, there are a few ways to boost it before applying for a loan. Make payments on time. Try not to close accounts right before applying for a loan. Also consider diversifying the types of credit you have.

2. Loan Amount and Term Length

A loan term is the agreed-upon amount of time you’ll have to pay a loan back to a lender. Longer terms often have higher interest rates, because the additional time poses more of a risk to the lender. Short terms result in lower interest rates. 

Think about it like this: would you feel more comfortable borrowing $50 to a friend if they promised to pay you back next week, or if they promised to pay in $10 installments over the course of a few months? Short terms mean lower risk and peace of mind for the lender.

3. Type of Installment Loan

Installment loan interest rates vary greatly depending on what the purpose and classification of the loan is. For example, credit card loans often have higher rates than mortgage loans. This is because a credit card loan is “unsecured,” meaning there is no physical collateral. “Secure” loans, like auto and mortgage loans, have a physical kind of collateral: if you don’t pay a car loan, you lose your car. Unsecured loans mean a lender has more to lose. Again, it all comes back to risk management.

4. Market Conditions

A lot of external factors can have high levels of impact on interest rates: the cost of labor and materials, inflation, production costs, supply and demand, and so on. A more tangible, specific example: the availability of homes will affect mortgage rates. Federal policy can also impact interest rates. “Key rates” set by the reserve reflect the state of the national economy and set an example for lenders.

5. Lender Policies

Other things that may impact interest rate offerings might be specific to a lender. The financial stability of the institution, for example, will be taken into consideration when assessing risk. Competitive rates with other institutions might also adjust interest rates, for worse or for better. 

How to secure the best installment loan interest rates

With all that in mind, how can you make sure you’re getting the best installment loan interest rates possible? If possible, try to select shorter loan terms. Focus on improving your credit score to qualify for low interest rates. Make sure to compare lenders or “shop around” before committing. Time your loan application based on well-researched trends in the market.

At Credit Central, we want the best for you and your money. Read more about our loan offerings here and apply online today.