Personal loans are a form of closed-end credit with predetermined monthly payments (e.g., three, four, or five years). Personal loan interest rates are expressed as a percentage of the amount borrowed (principal).
The quoted rate is the nominal annual percentage rate (APR), which is the rate that is applied to your loan annually. This rate includes all fees and other costs but excludes those associated with compounding and the impact of inflation.
Most personal loans actually use the monthly periodic rate, which is calculated by multiplying the annual percentage rate by 12. The APR (or periodic rate), when applied to the principal, establishes the additional sum you will have to pay in order to borrow the principal and pay it back over time.
Key takeaways:
- The interest on personal loans is calculated as a percentage of the amount borrowed.
- Most personal loans are unsecured, meaning they are not supported by recoverable assets or other forms of collateral.
- Personal loans without collateral have higher interest rates than loans with collateral.
- One of three methods—simple, compound, or add-on—is used to calculate the interest on personal loans, with the simple interest method being the most popular.
Understanding Personal Loan Interest Rates
Banks must first borrow money for themselves, either from other banks or from the deposits of their customers, before they can make loans. In addition to the inherent risk of lending money when there is no assurance that it will be repaid, the interest rate on a personal loan reflects how much it costs a bank to borrow money.
The interest rate on a personal loan is influenced by three key factors:
- Creditworthiness of the Borrower: Because they are less likely to default, borrowers with higher credit ratings typically receive better rates. The borrower’s employment and income may also be taken into account by the lender since these factors influence the likelihood of repayment. Due to the uncertainty surrounding their ability to make full payments, borrowers with low income or a history of missed payments frequently receive loans with the highest interest rates.
- The loan’s duration: Long-term loans are more profitable for lenders than short-term ones because interest can accumulate on the debt for a longer period of time. They consequently provide lower rates for loans with longer terms. If a borrower repays a loan early, some lenders may impose a prepayment penalty.
- The cost of borrowing: Banks borrow money from one another at an interest rate based on the federal funds rate, which is the cost of borrowing. The consumer then pays for this cost; if borrowing money is expensive, personal loan interest rates will be even higher.
The borrower’s ability to use collateral assets to secure the loan is a fourth consideration. This is covered in more detail below.
Unsecured vs. Secured Loans
The majority of personal loans are unsecured, which means the lender has no right to seize any assets as collateral. The cash you borrow to take a holiday could be an example of an unsecured loan. Due to the increased risk, the lender is taking, unsecured loans typically have higher interest rates.
Loans may also be secured, or backed by a valuable asset. Collateral is the thing you give the lender as assurance that you will pay back the loan. Because your home is used as collateral to ensure loan repayment, a home equity loan is an example of a secured loan. Because the lender assumes less risk, secured loans typically have lower interest rates.
You can compare the interest costs of a high-interest unsecured loan to a low-interest secured loan using a personal loan calculator.
Regulation Z
Regulation Z was put into effect by the Federal Reserve Board (FRB) in 1968, and as a result, the Truth in Lending Act (TILA), which was created to safeguard consumers in financial transactions, was born. Personal loans are covered by this insurance.
Lenders must disclose the APR, finance charge, amount financed, and the total of payments for closed-end personal loans under Subpart C—Section 1026.18 of Regulation Z. The number of payments, monthly payment amount, late fees, and whether there are penalties for paying off the loan early are all additional information that must be disclosed.
Average Interest Rate on a Personal Loan
As of November 2022, the average APR for a 24-month unsecured personal loan in the US was 11.23%. The rate you pay can vary from 6% to 36% depending on the lender and your credit score. For comparison, a secured new car loan with a 60-month term typically has an APR of 6.55%. This demonstrates how secured loans have a greater ability to reduce interest than unsecured loans.
Calculation of Personal Loan Interest
It is possible to make an informed decision when it comes to borrowing money if you are familiar with Regulation Z disclosure requirements and how interest on closed-end personal loans is calculated. There are three ways that lenders can calculate interest on personal loans: simple, compound, or add-on. These strategies all rely on the disclosed APR that is listed in the disclosure document.
Simple Interest Method
The simple interest method, also referred to as the U.S. Rule method, is the approach used most frequently for personal loans. Simple interest’s main characteristic is that the interest rate is always applied solely to the principal.
Simply enter the necessary information into Investopedia’s loan calculator using the example of a $10,000 loan at 10% APR for five years (60 months). In this instance, the initial term is 60 months, the initial principal balance is $10,000, and the interest rate is 10%.
The calculator returns the total principal and interest paid over the course of the loan, as well as the monthly payment. A detailed five-year amortization schedule that details the exact principal and interest payments you will make each month is also available.
The calculator illustrates how simple interest and on-time payments result in decreasing interest payments over time and increasing payments applied to the principal up until the loan is paid off. You will pay less interest overall and may even pay off your loan earlier if you pay your bills on time or make extra payments.
The amount of each payment that is applied to interest increases as a result of late or skipped payments, which means that less of each payment is applied to the principal. Interest is kept apart from late fees (escrow). At the conclusion of your loan, any accumulated principal, interest, or late fees are due. Test these claims by increasing, decreasing, or deleting payments to see how each affects the overall amount you pay.
Warning: Your credit score can suffer from a missed or late payment, making it more difficult for you to borrow money in the future.
Compound Interest Method
The results of the compound interest method also referred to as the “normal” or “actuarial” method, are identical to those of the simple interest method if all payments are made on time. This is because interest is never accrued. The same conditions apply when making additional or early payments. Both can lead to a shorter loan term and overall lower interest costs.
With a loan with compound interest, the accumulated interest is added to the principal if you are late or miss payments. The result of future interest calculations is “interest on interest.” This approach will result in even more interest and principal being left over at the end of your loan term. By entering the same numbers and choosing “Normal” as the amortization method, you can test these scenarios using the same online calculator. Compound interest is frequently used in mortgages, student loans, and credit cards.
Add-on Interest Method
Calculators are not necessary for the add-on interest method. This is so that the interest can be determined in advance, added to the principal, and divided by the number of payments (months).
Using the $10,000 loan example from above, multiply the starting balance by the APR times the number of years to pay off the loan to get the amount of interest you will pay: $10,000 x 0.10 x 5 = $5,000. Principal and interest total $15,000 in total. The $15,000 divided by 60 (the length of the loan) equals $250 in monthly payments, which are made up of $166.67 in principal and $83.33 in interest.
You will be required to pay a total of $15,000 whether you pay on time, early, or late (not including potential late fees). Examples of loans with added interest include money lent to subprime borrowers, payday loans, and short-term advances.
Example of Simple vs. Compound vs. Add-on Interest Methods
The comparison of simple, compound, and add-on interest rates for a $10,000 personal loan at a 10% APR over five years with and without missed payments is shown in the table below. The amounts displayed do not reflect late payment penalties or other fees, which vary depending on the lender.
- Column 1 displays the applied interest formula.
- Monthly payments are listed in Column 2.
- The total principal paid with on-time payments is shown in Column 3.
- Total interest is shown in Column 4.
- The amount paid in total is shown in column 5.
- The total principal paid over 57 payments is shown in column 6 (three missed).
- The total interest after three missed payments is shown in column 7.
- The total amount of unpaid interest and principal is shown in column 8.
- The total amount paid after three missed payments is shown in Column 9.
A comparison of the three approaches demonstrates unmistakably why you ought to eschew add-on interest at all costs. It also demonstrates how compound interest accumulates in cases of missed or late payments. The borrower benefits the most from simple interest, to sum up.
Which Bank Offers the Lowest Personal Loan Rate?
As of March 2023, Barclays had the lowest APR at 4.99%. However, other factors like the borrower’s credit score may affect your eligibility. There may be lower-rate lenders.
A Good Personal Loan Interest Rate?
As of March 2023, the average interest rate on a personal loan is 10.71%, and borrowers with good credit can get rates between 7% and 8%. You can get a better deal if you make a lot of money and have a good credit history, or if you can back up your loan with something of value.
What Are the Easiest Personal Loans to Get?
Sadly, the personal loans with the lowest interest rates are also the ones that are easiest to obtain. While credit card rates can be as high as 20%, payday lenders may charge as much as 780% APR.
Since almost anyone can be approved for one of these loans, their interest rates are high.
The Bottom Line
By following the tips provided here, you can better assess which personal loan and interest rate are best for you. Personal loan interest rates vary.
