How are personal loan amount and interest rates determined?

Personal loans from the same bank can be offered at different rates to the different customers. This is because the banks determine their interest rates which are based on the individual’s profile and other details. The article tells us as to how it works.

What is a personal loan?

Personal loans are unsecured loans which mean that an individual doesn’t have to provide any collateral with the financial institution from which he borrows. Unsecured loans are usually more expensive when they are compared with secured ones because the banks don’t have any collateral which they can pledge in case individual defaults. So, a personal loan would be more expensive than a home loan.

It All Starts with the Interest Rate Policy

Banks are generally free to determine the interest rate they would pay for the deposits and charge for loans, but they must always take the competition into account, as well as the market levels for the numerous interest rates and policies. The Reserve Bank of India influences interest rates by setting of certain rates, stipulating the Cash Reserve Ratio and Liquidity Reserve Ratio requirements and also by buying and selling of “risk-free” bonds (also known as Treasury Bonds, a term which is used to indicate that these are among the safest bonds in existence because they are guaranteed by the Government of India)

Other considerations that the banks may thus take into account are the expectations for inflation levels, the demand and velocity of money domestically and internationally, the stock market levels and the other factors that are discussed below:

Market-based Factors

Also, the banks look to maximize the interest rate by determining the steepness in the yield curves. The yield curve however basically shows in graphs the difference between short-term and the long-term interest rates. Generally, a bank looks to either borrow, or pay the short-term rates to the depositors, and then lend, through the making of the loans, at the longer-term part of the yield curve. If a bank can do this successfully, then it would make money and please shareholders.
Also, local market considerations are important. Smaller markets may, however, have higher rates due to less competition, as well as the fact that the loan markets are less liquid and they have a lower overall loan volume.

Client Inputs

A bank’s prime rate – the rate that the banks charge to their most credit-worthy customers – is the best rate which they offer and they assume a very high likelihood of the loan which is being paid back in full and on time. But as any of the consumers who has tried to take a loan knows, a number of other factors also come into play.

The amount of money which is put down as a down payment – be it none, 5%, 10% or 20% – is also considered as important. Studies have thus demonstrated that when a customer puts down a large initial down payment, then he or she has sufficient “skin in the game” to not walk away from a loan during the tough times. The fact that the consumers put a little money down (and even take the loans with negative amortisation schedules, meaning that the loan balance increased over time) to buy homes during the Housing Bubble is seen as a huge factor in helping to fan the flames of the credit crisis and also ensuring of the 2008 recession.
The collateral or putting of one’s other assets (home, car, another real estate) into the loan terms, also influences the skin in the game. The loan duration, or how long till the period of maturity is also considered as important. With a longer duration comes a higher risk that the loan would not be repaid. This is thus generally why the long-term rates are considered as higher than the short-term ones. Banks also thus look at the overall capacity for the customers to take on debt.

The Bottom Line

Banks use an array of factors which are used to set the interest rates. The truth is, that they are looking to maximize profits for their shareholders. On the flip side, however, the consumers and businesses seek the lowest rate which is possible. A common sense approach for getting a good rate would thus be to turn the above discussion on its head, or either look at the opposite factors from what a bank might be looking for.

By | 2017-11-04T06:58:54+00:00 March 28th, 2017|Loan|Comments Off on How are personal loan amount and interest rates determined?

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