How Personal Loan Interest Rates Work

Have you ever wondered why different applicants are quoted different interest rates for personal loans? While the creditworthiness of the borrower certainly plays a big part, it is by no means the whole story. Loan interest rates are modeled on a mix of factors, and one of the simplest examples is the Cost-Plus loan pricing model. It is made up of four components:

Funding cost.
Operating costs.
Risk premium.
Profit margin.

Let’s explore each of these in more detail.

The Cost of Funding

A lender can only operate if it in fact has money to lend out. Where does the funding come from and how much does it cost?

A company lends out funds it has acquired either internally or externally. Internal funding stems from a company’s equity – the money it raises from investors and the profits it accumulates in retained earnings. The cost of equity is the compensation investors require in return for their investment in the company. The cost of retained earnings also approximates the return required by outside investors.

Many personal loan providers are private companies which might not have outside investors, as sometimes only the owner contributes capital to the business. It is difficult to evaluate a private company’s equity cost because the usual formulas (i.e., the dividend growth model and the capital asset pricing model) depend on factors like dividends and public share price, neither of which need to exist for a private business.

The other funding source is debt, starting with the Federal Funds rate, which is the target interest rate set by the Federal Reserve. It is the rate at which commercial banks lend and borrow excess reserves overnight to each other. The Fed Funds rate establishes the floor cost a lender faces when making loans. It is the starting point for pricing a personal loan.

If a lender uses a mix of equity and debt funding, it can (in theory) calculate a weighted-average cost of capital that represents the economic cost of acquiring loan funding.

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Operating Costs

Before a lender can even think about profits, it must first cover its costs. We’ve touched upon the cost of funding. Operating costs refer to the required spending for servicing a loan, processing applications and payments, the salaries and/or draw of employees and owners, rent, utilities, etc. Online-only lenders minimize operating costs by avoiding brick-and-mortar branches and the employees to run them. Efficient lenders can charge lower interest rates than can the ham-fisted variety.

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Risk Premium

The risk premium is how much a lender charges to protect itself in case a borrower defaults on a loan. The premium calculation includes well-known factors pertaining to the borrower, including credit score and credit history. On the FICO scale of 300 to 850, scores above 700 are generally considered good and will usually result in a smaller risk premium compared to sub-700 scores. In this way, folks with good credit don’t subsidize deadbeats, which would be the outcome if all paid the same risk premium.

The loan characteristics, such as loan amount, repayment term, fees, and prepayment penalties, all impinge on the risk premium. For example, a shorter term creates larger monthly payments that are riskier. A higher loan amount increases the lender’s cost of default. In general, the risk premium is the component responsible for interest rate variation.

Naturally, unsecured loans require a higher risk premium than do secured loans. With a secured loan, the lender has a lien on the collateral property that reduces or eliminates the cost of defaults. Most personal loans are unsecured, but if you are in a position to deposit collateral, a secured loan will almost certainly increase your access and decrease your interest rate.

Profit Margin

Lenders are out to make money, just like everyone else. A good lender keeps their greed in check to some extent and operates with a reasonable profit margin.

Profit is what’s left over after you account for all costs – funding, operational, and risk premium. In a private business, the owner has the last word on the required profit margin. That differs from public corporations that must provide an adequate return on invested capital. Some lenders will be satisfied by a 1% profit margin, while others will need profits in the double digits. To some extent, the required profit margin is arbitrary – a company could stay in business even with zero profits as long as its revenues covered all of its costs.

A Word About Competition

Lenders can’t set interest rates in a vacuum. In reality, they are competing with other lenders and therefore must keep their interest rates in line. The Price-Leadership model accounts for competition and can impact a lender’s profit margin. In short, this model narrows the range of profit margins on loans to the best borrowers. Risk premiums are added to the prices of loans made to leading customers with the best credit.

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Eric Bank

Eric Bank is a business and personal finance writer who has been featured in Credible, Wisebread, CardRates, Zacks and many other outlets. He holds an M.B.A. from New York University and an M.S. in Finance from DePaul University.