Personal loan interest rates are affected by borrower’s risk factor and lending bank’s borrowing rate. Personal loan interest rates can vary significantly for the same borrower. Different banks assess borrower’s risk differently. Also, different banks have borrowing costs. Before you commit yourself to a specific bank, make sure you compare personal loan interest rates from all banks.
A bank borrows money from various sources including:
Different sources cost the bank different interest rates. The bank needs to pay interest on the borrowed money. Interest rates on persona loans are higher than the bank’s borrowing interest rate.
Let us assume that the bank’s average cost of borrowing money is 6%. The interest rate for personal loan will be:
Cost of Borrowing (6%) + Risk Factor (x%) = Personal Loan Interest Rate (6+x%)
Different banks provide personal loans to different risk categories. Some banks offer personal loans to risky lenders. Others restrict themselves to safe borrower.
Bank A lends personal loans to safe borrowers at a low interest rate. Bank B lends personal loans to risky borrowers at a high interest rate.
Bank A offers a personal loan interest rate of 8%. They expect all their customers to repay the loan. Bank A makes 2% (8% interest income – 6% cost of borrowing) every year on the money it lends to a customer. Banks offering low interest rates do not expect borrowers to not repay the loan. They use the 2% earnings to pay for expenses and profits.
Bank B lends personal loans to risky borrowers. Risky borrower are likely to default. Out of every 15 borrowers, Bank B estimates only 13 will repay the loan. To compensate for this higher risk, Bank B charges 25% interest rate. This is higher than Bank A’s 8% interest rate.
Bank B earns 19% profit from every customer. Given only 13 borrowers repay the interest and borrowed money, Bank B earns 247% (19% Interest X 13 Borrowers) as interest. Two of the risky borrowers do not repay the personal loan. This costs the bank 200% (100% loan amount X 2 Borrowers who do not repay) as loss. The bank’s profit is 3.13%% (247% Profit – 200% Loss divided by 15 borrowers).
Both banks make money. But, their personal loan interest rates vary significantly.