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How do loan interest rates work?
Interest is the add-on rate that a borrower needs to pay for borrowing money. Simply put, it’s the price that lenders’ put on the money borrowed to generate maximum profit. This excludes processing fees and other charges to be paid upfront. Interest rates vary based on 1) lender 2) type of loan 3) borrower background and 4) loan repayment term. Interest rate is expressed as an annual percentage of the principal amount borrowed.
Based on Lender – Banks and financing companies often lower or raise their rates according to market competition, thus they advertise “competitive rates”.
Base on Type of Loan – Collateral loan has lower rates compared to non-collateral loan. With collateral loan, the borrowers stand to lose the property (vehicle or real estate) once they fail to pay the loan. In cases such as a default, lender will have to recoup the loss by selling the property. On the other hand, non-collateral loan is riskier to the lender than the borrower because they don’t hold anything of value from the borrower in case the borrower defaults. So the rates of a non-collateral loan includes the added risk involved to manage losses.
Based on Borrower Background – Most of the time this applies to a non-collateral loan which carries a huge risk for lenders, thus their one and only insurance is to determine if the borrower is credit-worthy (meaning you have high likelihood of repaying the loan). What do they look for to consider a person as credit-worthy?
Years employed – lenders need to know if you can keep a stable job, thus securing a consistent income.
Monthly net income – lenders use income to determine how much you can borrow and how much you can afford to pay monthly minus all your monthly obligations (bills, government dues etc.) Tip: Lenders approve loan amount that is thrice or four times your monthly net income.
Credit history – lenders have access to credit bureaus, banks and other sectors to determine if you have cancelled credit cards, bounced cheques, poor repayment history. Even court cases filed against you is a negative sign and go against your good character.
Nature of the Company – Lenders also look at the background of the company you work for to make sure they won’t easily file for bankruptcy thus leaving you without a source of income. Most lenders require borrowers to be employed to a company that has been in operation for 2+ years.
Based on Loan Term – The longer you want to pay back the loan the higher the interest rates will be. Longer loan repayment term has a higher risk of non-repayment, taking into account many possible unknowns that may happen within that span of time. For example, in three years’ time you may lose or quit your job, your company may close, and a dire emergency might force you to forego payments or not pay at all. All these scenarios are considered by lenders thus they try to balance the risk with early returns.
Do banks follow lending rates guideline set by BSP?
BSP or Bangko Sentral ng Pilipinas as a regulating body has not set specific threshold for lending rates since 1983. The BSP follows a market-oriented interest rate policy which allows the banks and lenders and pawnshops to set its own rates. However, they require lending companies to be 100% transparent to borrowers and that interest rates applied must be duly indicated on loan agreements, promissory notes and/or pawn ticket.