How are personal loan amount and interest rates determined

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How are personal loan amount and interest rates determined

Personal loans from the same bank can, however,  be offered at different rates to the different customers. This is because the banks determine their interest rates which are based on the individual’s profile and other details. The article tells us as to how it works.

What is a personal loan?

Personal loans are unsecured loans which mean that an individual doesn’t  have to provide any collateral with the financial institution from which he borrows. Unsecured loans are usually more expensive when they are compared with secured ones because the banks don’t have any collateral which they can pledge in case individual defaults. So,  personal loans would be more expensive than a home loan.

It All Begins with the Interest Rate Policy-

In theory, banks are free to set the interest rate that they would be willing to pay for deposits and charge for loans, but practically they have to always take in to account various factors like, the competition, the market levels of the numerous interest rates and monetary policies. The Reserve Bank of India influences interest rates by setting of certain rates, stipulating the bank reserve requirements and also by buying and selling of “risk-free” (a term which is used to indicate that these are however among the safest bonds in existence)

Other considerations that banks may take into account are the expectations for inflation levels, the demand and velocity for money throughout the country and internationally, the stock market levels and the other factors that are discussed below.

Market-based Factors-

The banks look to maximize it by determining the steepness in the yield curves. The yield curve however basically shows in graphic form, the difference between short-term and the long-term interest rates. Usually, a bank when borrowing pays interest at short-term rates to the depositors, and then, lends loans, at longer-term interest rates leading to a yield curve. If a bank can do this successfully, then it would make money and please shareholders.
Also, local market considerations are thus important. Smaller markets may, however, have higher rates due to the less competition, as well as the fact that the loan markets are less liquid and they have lower overall loan volume.

Client Inputs-

A bank’s prime rate – the rate that the banks charge to their most credit-worthy customers – is the best rate which they offer and they assume a very high likelihood of the loan which is being paid back in full and on time. But as any of the consumers who has tried to take out a loan knows, a number of other factors also come into play.

The amount of money which is put down as a down payment – be it none, 5%, 10% or 20% – is also considered as important. Studies have thus demonstrated that when a customer puts down a large initial down payment, then he or she has sufficient “skin in the game” to not walk away from a loan during the tough times. The fact that the consumers put a little money down (and even  had the loans with negative amortisation schedules, meaning that the loan balance increased over time) to buy homes during the Housing Bubble is however  seen as a huge factor in helping to fan the flames of the credit crisis and also ensuing of great recession .
The collateral or putting of one’s other assets (home, car, another real estate) into the loan terms, also influences the skin in the game. The loan duration, or how long till the period of maturity is also considered as important. With a longer duration thus comes a higher risk that the loan would not be repaid. This is thus generally why the long-term rates are considered as higher than the short-term ones. Banks also thus look at the overall capacity for the customers to take on debt.

The Bottom Line-

Banks thus use an array of factors which are used to set the interest rates. The truth is, that they are thus looking to maximize profits for their shareholders. On the flip side, however, the consumers and businesses seek the lowest rate which is possible. A common sense approach for getting a good rate would thus be to turn the above discussion on its head, or either look at the opposite factors from what a bank might be looking for.

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By | 2017-05-17T12:50:28+00:00 April 3rd, 2017|Entrepreneurship, Loan, personal loan|Comments Off on How are personal loan amount and interest rates determined

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