When you take out a loan of any kind — be it a mortgage, a personal loan, a car loan — or open a new credit card, you will pay interest on the borrowed money until you pay it back.
When lenders look at your financials, they assign you an annual percentage rate, or APR, based on the type of loan, your credit score and your risk profile. The better your score, the lower your APR — and the less you pay over time. On the other hand, if your score is lower, lenders might worry you’ll default on your payments, so you’ll be charged a higher interest rate since you’re considered more of a risk.
Interest and APR are simple concepts in theory. But knowing what APR to expect when you apply for a personal loan, mortgage, car loan and/or a new credit card is a different story.
To help you feel confident that you’re getting the best APR, we broke down the top factors lenders look at when deciding what interest rate to charge you.
Why and how banks charge APR
When deciding what APR to charge their customers, banks use the prime rate as a starting point. The prime rate is determined by the Federal Open Market Committee and is about the lowest rate you can expect to get on mortgages and some other types of loans if you have a good or excellent credit score. In other industries, such as credit cards, lenders add an additional margin on top of the prime rate.
For instance, the Chase Freedom® offers a variable APR ranging from 14.99% to 23.74%, which is a lot higher than the prime rate of 3.25% (as of October 2020).
But it’s not all bad news: Just as you would shop around for the best price on a pair of shoes or scout a good deal on new furniture, you can also shop for loans and credit products with lower APR.
Learn more: Why are credit card APRs so high?
The factors lenders consider when determining your interest rate
As you shop for a low-interest loan or credit card, remember that banks are also “shopping” for reliable borrowers who make timely payments. With that in mind, financial institutions will look at your credit score, income, payment history and, in some cases, cash reserves when deciding what APR to give you.
To get approved for any kind of credit product (credit card, loan, mortgage, etc.), you’ll first submit an application and agree to let the lender pull your credit report. This helps lenders understand how much debt you owe, what your current monthly payments are and how much additional debt you have the capacity to take on.
For big-ticket loans, such as mortgages, you’ll also need to submit additional documents showing how much money you have in the bank, along with income and other assets.
Taking these documents into account, the bank or lender assesses your creditworthiness. If you appear to pose a high risk of defaulting, the lender may reject you outright or simply increase your APR.
Here are some factors that go into determining your APR:
- Type of credit product: According to the Fed’s latest data, personal loans have an average APR of 9.34%, and car loans are at 4.98%. Thirty-year fixed-rate mortgages are averaging 2.81% this week, according to Freddie Mac.
- Credit score: A higher score qualifies you for the lowest interest rates.
- Payment history: More on-time payments makes you a competitive applicant for lower rates.
- Interest rate type (fixed or variable): Fixed-rate loans charge the same APR throughout the lifetime (term) of the loan. Variable-rate loans fluctuate, meaning you could potentially save money but also be charged more if rates go up.
- Loan term (if applicable): Typically, the longer the loan term, the higher the interest rate will be (but not always). That’s because shorter terms guarantee the lender will have their money back sooner, so there’s less risk.
- Down payment (if applicable): You might qualify for a lower rate by making a larger down payment.
- Perks and rewards (if applicable): Credit cards with better rewards programs tend to have higher APRs.
- Location: Mortgages in particular are influenced by state and municipal governments. Every state may have unique taxes, property laws, grants and/or regulations that can impact what your mortgage will cost you.
How your APR is calculated
APR is expressed as a percentage in terms of what you pay over a year. If your mortgage APR is 4.5%, for instance, you make monthly payments that end up being about equivalent to 4.5% of the average daily balance over the course of 12 months.
Likewise, you pay interest on your credit card every month you carry a balance past your grace period. Keep that balance for a year, and you end up paying interest charges equivalent to your APR. If your APR is 22.99% and your revolving credit card balance averages out to $5,000, that’s $1,149.50 in interest paid per year (billed on the months you have a balance) until you pay it off.
Interest is a simple concept, but understanding how it’s billed can be a little tricky. Read more about how APR is calculated here.
Don’t miss: How the prime rate works and how it affects you
How to prepare for an upcoming application
If you know you want to apply for a loan, mortgage and/or credit card in the near future, prepare now by looking at your credit report. Experian offers a free credit monitoring service that allows you to see your borrower profile and get an updated Experian credit report and FICO credit score every 30 days.
Once you know your credit score, you can have a more clear sense of the interest rate you might get. The closer you are to having prime or super-prime credit, the more likely you will qualify for the best APRs.
Some experts say that reaching a credit score of 760 will get you the best deals on everything from mortgages and car loans to credit card rewards.
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Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the CNBC Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.