Understanding Interest Rates for Different Loan Types

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Many folks are familiar, to some extent, with borrowing money and paying it back with interest. It’s quite a common practice. Generally, borrowing is very helpful in creating opportunities for personal and commercial endeavors alike. Individuals can borrow money to put a down payment on a car or home thus, having an established means of building equity. Entrepreneurs can acquire the funds necessary to pay the start-up costs of a business such as property, equipment, and hiring skilled labor needed to establish recurring revenue.

Sometime borrowing money has resulted in someone becoming far deeper in debt than when they started. Payments laden with interest have become too much to keep up with and those involved have had to liquidate assets just to pack back the growing debt. It’s not a situation people want to risk and the has idea been the foundation of some folks’ avoidance to borrowing altogether. It has even caused some to look unfavorably upon lending institutions believing them to use interest in the exploitation of people’s desperation.

The truth is this: borrowing is a tool that can be used to build a future or, if used incorrectly, one that can destroy opportunity. Let’s take a closer look into what all is involved with borrowing and apply that knowledge to a few examples.

Identification and Credit Checks

Anytime money is being borrowed you can be sure proof of identification is expected. Any lender is going to want to know to whom they are lending money. That’s a given. Next, a lender usually, though not always, wants to be convinced that a potential borrower can afford, or will be able to pay back, the loan. Let’s put you in the roll of the lender for a moment.

Imagine you have a neighbor from down the street who approaches you one day. We’ll call him John. He asks to borrow $200 to fix his wife’s car. She’s rejoining the workforce now that their daughter is old enough for school and will need to be able to commute on her own. It’s an odd request to make of someone you don’t know so you tell him you would like more time to think it over. He seems like a nice fellow and sounds sincere so, you decide to look into the matter a little further.

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You remember when John and his family moved in down the street. You have seen him come and go enough to have it firmly established in your mind that he’s a permanent resident at that house. You confirm this by looking up the address online and get the opportunity to see his full name: John Kramer. You write all this information down because it only makes sense to know to whom you’re lending money, if it comes to that.

Next, you talk to a few of your neighbors about John to get their opinion of his character. One of them, Mr. Samuelson, mentions how John once borrowed money from him a few years back. Mr. Samuelson goes on to say that he had no trouble whatsoever and that John, expressing strongly that he was not after charity, insisted on paying the money back with interest.

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Convinced that John has integrity, you go over to his house for one more piece of information. It’s a nice home and well kept. Upon seeing your approach John comes out to greet you. You tell him that you have no problem lending him the money provided he can vouch for his current employment and that the loan won’t be too much to pay back.

John invites you inside where he introduces you to his wife and daughter and then produces a pay stub from last week’s paycheck. You know that you have the correct name and employment status. You also confirm that he makes enough to not have any trouble paying back the money, especially with the additional income of his wife, Jen. Additionally, she provides both their work phone numbers so you may confirm the provided information. Finally, fully satisfied that this will be an opportunity to help out a neighbor and that he will have no trouble repaying the money, you and John begin to work out the details.

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In this process you’ve verified John’s identity and address. You performed a credit check on him by speaking to Mr. Samuelson who illustrated John’s character and payment history. You also evaluated his assets when you took notice of the condition of his home and confirmed his employment and salary. Jen gave you their work numbers allowing you to further confirm their work status. You did the very things a lender is expected to do.

Interest Rates and Risk

Interest rates. There’s a phrase that often causes a negative reaction in people. All professional lending institutions have interest rates. Between different lenders interest rates can vary greatly. Some rates can be very low, like some mortgages (respective to the percentage rather than the amount that comes with such a large purchase). Other interest rates can potentially skyrocket.

Does this mean high rates are the product of greed or exploitation? Well, while not outside the realm of possibility, high rates often accompany specific types of loans that differ in purpose and risk to the lender.

First, let’s get familiar with the reason for interest to be charged. Interest rates exist in order to promote lending. A business can’t very well stay a business if it does not make a profit. Being able to profit by lending money gives companies incentive to offer loans and creates many opportunities for both borrower and lender.

A lender assigns a nominal rate which is the percentage of interest charged that accumulates profit. The lender then receives the real rate which is essentially the nominal rate however, it takes inflation into account the fact that the nominal rate may not be able to buy what it could when the loan was established thus it is a reflection of what the interest rate is actually worth.

Getting back to low versus high rates, we see car loans and mortgages often see relatively low rates. This is partly due to the credit checking that goes into approving a potential borrower. Mortgage loans, similar to vehicle loans and some bank loans, are secured loans. This means if a borrower not be able to make payments, there is collateral (property, vehicles, or other assets) that may be collected by the lender thus, preventing or reducing financial loss through lending. These loans are often lengthy and have plenty of time to profit within.

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Higher rates are common among loans that are unsecured. The highest of these often being payday loans and cash advances. Some lenders of these types of loans, will forego reviewing credit scores and so are made at a much greater risk to the lender.

The other contributing factor leading to a steeper interest rate is the length of time the loan spans. Payday loans and other such loans are intended to span over very short periods of time. There isn’t much time to make profit on these loans so the rate is higher to make lending over these short periods appealing to a lender.

An added benefit of these loans is that they are also very quick to be approved and cash can be added to one’s checking account the very next day.

Where folks find themselves in trouble usually has something to do with how they borrow. They extend the loan further than its intended duration or skip a payment on short-term loans.

Remember, the rate is higher because this type of loan is meant to be shorter. Some individuals borrow more than they know they can pay back. Borrowing like this seldom ends well. It’s important to know what kind of loan to get and to use it as intended. When one does that, both the lender and the borrower have a good and productive experience.

Getting back to neighbor John, let’s take a look at how a short term loan works out. John is still against accepting a loan without paying it back without interest. He feels he can pay for what he wants with a little time and wants both parties involved to benefit which is a noble part of his character. You and John agree that he’ll pay back the loan over the next two weeks. He insists making $125 payments on the next two Fridays totaling $250. It seems fair but, if we take another look, we see that is an interest rate of 25%.

Naturally, as a neighbor and not in the business of lending, you wouldn’t think of charging more. Of course, being a neighbor and having done character and asset evaluation, you have required more information than some lenders and were able to substantially reduce your risk. If John lived in a dilapidated house and Mr. Samuelson had given you a bad report about John’s character would you still have loaned him the money? Even at half the amount?

Luckily, both you and John went about this the smart way and with integrity. Now John’s wife, Jen has a working vehicle and you are $50 richer.

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Hopefully this gives you a better idea of how loans and interest rates work as well as illustrating the benefits of getting the right loan.