Many consumers have begun to look into debt consolidation loans as a way to simplify their financial situation and to reduce the amount they pay each month. This makes sense, as debt consolidation loans are an excellent tool to do both of those things.
However, in order for a consolidation loan to actually lower your payments, you need to get the loan at a lower average interest rate than the debt you are consolidating. While it’s usually easier to get a better interest rate from a consolidation loan than for other financial products, you still need to understand how companies determine your interest rate. Understanding how interest rates are set will not only help you get a lower rate, but will open up doors to the lowest possible rate for your debt consolidation loan.
This guide will cover credit scores and interest rates, some ways to improve your credit score, and will tell you what you need to look at besides interest rates when comparing loan options. If you’re tired of turning out your pockets every month to pay your creditors, then this information is for you.
Understanding Interest Rates
Before we tell you how to get a low interest rate, it helps to understand exactly what an interest rate is. Interest rates are how lenders make money on the funds they lend out. After all, lending someone $1,000 and getting $1,000 back doesn’t pay the bills or turn a profit.
It’s helpful to understand interest rates and loans as a risk/reward dynamic. Whenever a lender loans money, they are taking a risk that the person receiving the loan won’t be able to take it back. The profit the lender makes on the interest rate is the reward they get for taking the risk.
Therefore, individuals who are seen as more likely to repay the loan, and thus are lower risk, can get money for a lower reward to the lender than other consumers. Borrowers who present a greater risk of default need to generate a higher reward in order to make the risk worth it. Therefore, higher-risk borrowers receive higher interest rates.
This same dynamic underlies nearly all business decisions. Businesses are rewarded for taking risks with their capital. A company that invests money into a new manufacturing process is hoping the reward will justify the risk. If the reward is a 50% increase in productivity, and the risk is a 10% increase in costs, then it makes sense to take the risk. However, if the reward is a 10% increase in productivity and costs go up 10%, then there’s not much, if any, reward to be had. Therefore, the company will be unlikely to take the risk.
Credit Scores and Interest Rates
One of the biggest factors in determining your interest rates is your credit score. A credit score is a numerical expression of how much of a risk of default you present to potential lenders and creditors. A credit score is made from several different assessments, including:
- Payment history – this includes any late or missed payments you might have, and accounts for 35% of your score
- Amount owed – how much you own in all of your accounts. This category is heavily influenced by the percentage of your revolving accounts you’re using. It accounts for 30% of your score
- Length of Credit History – how long ago you opened accounts and how long it’s been since they had activity. 15% of your credit score
- Types of credit used – this category analyzes the mix of revolving and installment debt in your accounts
- New credit – how intensely you’re looking for new credit, including credit inquires and any new accounts you’ve opened
As you can see, these five categories combine to present a fairly accurate picture of your risk level to potential lenders and creditors. After all, if you’ve missed many payments in the past, then chances are good that you’ll miss payments with your new creditor as well.
People with a higher credit score are seen as less of a risk of default. Accordingly, these consumers get more favorable interest rates than those with a lower credit score so that the risk/reward dynamic makes sense for the lender.
Improving your Credit Score
One of the best ways to lower your interest rates is to improve your credit score. However, this can be a tricky task. Credit and debt counselors will know different strategies and tactics you should use, and can offer more specific advice.
Generally, paying your bills on time is the best way to boost your credit score. What lenders like to see most is that you meet your financial obligations. You can also use credit repair methods to challenge inaccurate and negative information on your credit report in an effort to get it removed and boost your score.
You can also boost your credit score by reducing the amount of revolving credit you use. Revolving credit covers things like credit cards. One popular way of lowering your credit utilization is to take out a consolidation loan. This transforms your revolving debt into installment debt, and can boost your credit score. Be warned though, the initial effect on your score will be a slight dip before your score starts to climb up again.
Compare More than Rates
Interest rates aren’t the only thing you should look at when comparing different financial products like consolidation loans. Savvy consumers know that you also need to make sure you understand the fee structure and any other charges you might incur when getting a loan. These include things like origination fees, early repayment penalties, late payment penalties, and any introductory offers like reduced or zero interest periods.
Understanding the different features and charges of different loans will let you calculate the total actual cost of the loan. While the loan that has the lowest interest rates will usually have the lowest total cost, that’s not always the case. That’s why it’s so important to understand the terms of the loans you’re considering so that you can make the best financial decision for your particular needs.