Interest rates determine the cost of borrowing money from financial institutions and are typically expressed as percentages. That seems easy enough, but things can get a bit more complicated when it comes to figuring out how rates are determined. It’s actually not as complicated as it may seem.
Lenders take several factors into consideration when setting these all-important rates. Here’s a closer look at what they are and what you can do to get the lowest rates possible.
Higher credit scores can mean lower rates
Credit scores, which generally range from 300 to 850, play a vital role in shaping interest rates. The higher your score, the lower your rates will typically be, since you’ll be considered more financially reliable and more likely to make loan payments on time.
Lower rates mean you’ll pay less interest on your loan. Over the course of a 30-year mortgage, you can save thousands of dollars if you manage to get a low rate instead of one that’s a few points higher.
That means it’s a good idea to strengthen your credit score — if you can — before taking out a loan. Aim for a score of 740 or higher, which may be accomplished by eliminating as much debt as possible, paying credit card bills in full and on time, and using no more than 30% of your credit limit.
Larger down payments can reduce rates
When taking out a mortgage, most lenders will require you to pay a percentage of the total cost of the home upfront. That’s your down payment. Generally speaking, the more money you can put down right away, the lower your interest rates will be.
Shorter terms can have lower rates
Every loan has a term, which is simply the time you’ll have to repay what you’ve borrowed. Although home loans can have terms as long as 30 years, auto loans range from about two to seven years. The shorter the term, the higher your monthly payments will be. However, interest rates tend to be lower with a shorter term.
Adjustable rates can be a good option
You also may be able to choose between fixed and adjustable interest rates. Although adjustable rates tend to start out lower, they can change over time, meaning your monthly payment could increase.
Although several of the factors we’ve identified are out of your control, you can — and should — start slashing your debt and continue to pay your bills every month. This can improve your credit score, which in turn can help you obtain lower rates on future loans. It’s in your best interest. (Pun intended.)
Tony Armstrong, guest author, NerdWallet