The rate of interest charged against a loan can vary quite dramatically. The factors that affect the interest rates include information about the borrower and the institution that is doing the lending.
The Central Bank
The central bank of a country sets a rate of interest at which the commercial banks can borrow over-night. This rate of interest is usually set by the central bank a part of the control of the money supply. When the rate of inflation falls, the interest rate is often lowered to encourage a greater take-up of credit. When inflation is rising, the rate of interest is generally increased as a measure to help to counter inflation. While the rate of interest charged to individuals and business may vary, all are based on the rate of interest charged by the central bank.
Risk is the first major factor. Risk can be influenced for a number of reasons and it is the risk assessment that will determine the interest rate that is to be levied against a loan. In some cases a fixed rate of interest will be set for the duration of the loan, but more often, the rate is set in terms of its relation to prime. Prime is a rate set by the banks following the rate of interest set by the central bank. As a general rule, a high risk loan will attract a high rate of interest – prime plus n, while a medium or low risk customer will be given a lower rate of prime, perhaps even below prime.
Business Loans – Start-ups
Lenders often see business loans as more risky than personal loans. This is particularly true when the money is needed for a start-up business. A start-up business is generally a fairly risky venture. Over half of new businesses fail in the first year. If the lender is willing to loan the money at all, the rate of interest charged will probably be at a premium.
The factors that the lender will look at include the business plan – have you made sufficient provision to cover a realistic cash flow? How much money is the borrower putting into the business? When the borrower has a substantial investment in the business out of his own funds, there is less chance of default than when all the money comes from the bank.
The lending institution is obviously taking a risk when lending money against a start-up business. There is always a risk that the business will fail and the loan will not be recovered easily. Apart from looking at the business plan itself, the lender will examine the credit record of the borrower. How good has the borrower been in the past at repaying loans?
Business Loans – Existing businesses
Often an existing business requires credit to maintain its cash flow or to invest in new equipment. Again, the lender will assess the risk and determine the interest rate.
When it comes to personal loans, it is usually the credit rating of the individual that is the primary factor when setting a rate of interest. A poor credit will ensure that a high rate is charged if finance is given at all. A high income coupled with a good credit record should ensure a low interest rate.
The purpose of the loan could be a factor in determining the interest rate. A loan is required as a rescue measure is likely to attract a higher rate than a loan required for the purchase of goods.
The Lending Institution
Every bank has its own unique way of assessing risk. One factor may play a bigger part for one lender than for another. So when it comes to negotiating a loan, it may be a good idea to shop around. Organisations that provide short term emergency loans charge very high rates of interest. These are companies that provide pay-day loans as well as pawn shops. Both charge really astronomical rates, but are there when the need for money has become desperate. Pawn shops will advance their own valuation of goods when you need it. To redeem your goods, add on about 20% at the end of the month!
People that are unable to get finance from more conventional lenders may be forced to borrow from these short-term lenders that don’t require a credit rating. Being the only supplier that will provide credit places pawn shops into the strong position that allows for very high rates to be charged.