Understanding The Concept Of Loan Rate

by : Sam Miller

When applying for a loan, the prevailing loan rate is one of the primary considerations. Loan rates may differ from one financial institution to another, depending on the loan amount and credit risk involved.

One of the major functions of financial institutions, like banks, is to provide loans as prospective lenders. As lenders, they release an amount of money to a debtor, which the latter typically pays through regular installments. Generally, loan services are provided at a cost, usually referred to as the interest on the debt, or loan rate.

Loans are basically categorized into two, secured loan and unsecured loan. In a secured loan, a borrower or creditor pledges some of his assets as loan collateral. The most common type of a secured debt instrument is the mortgage loan, which many people use to purchase and finance housing. In this setup, the money lent by a financial institution is used to purchase a real estate property. The creditor or the financial institution, however, takes a lien on the house title until the loan has been fully paid off.

Unsecured loans, on the other hand, are monetary loans that borrowers can avail of without having to use any of their assets as loan collateral. Some of the most common examples of this type of loan are personal loans, bank overdrafts, lines of credit or other credit facilities, and corporate bonds. Because there is a lower risk of default for secured loans, they often come with lower interest rates. In addition, it is possible that borrowers will have higher approved loan amounts with secured loan.

There are various factors that could affect the interest rate on a debt instrument. The most prevalent factor that influences loan rates is inflation. When inflation is higher, there are fewer parties or entities that are willing to lend their money at the current interest rate. As a compensatory measure, loan rates generally increase during high inflation in order to compel creditors into lending their money. Interest rates are also highly related to credit risk. The higher the risk of default, the higher the interest rates imposed would be. Credit risk is usually assessed by looking at the credit score or credit history of a loan application. A good credit score is characterized by no default payments or loan reconstruction of past credit transactions. Aside from obtaining credit ratings of consumers from credit bureaus, credit evaluators also check the bank accounts of loan applications.

Nevertheless, there are measures that can be undertaken to be able to avail of lower interest rates from financial institutions. One of which is to make prompt payments and to maintain good credit standing. Financial institutions usually use the credit score as basis for loan approval. A credit score is determined through two factors, credit history and income level. With a higher credit score, a prospective debtor is almost always guaranteed lower interest rates. It would also help to shop around various loan providers in order to compare and determine which among them offers the lowest loan rate.