What affects personal-loan interest rates?

Back when we were kids, borrowing money was a simple affair. You'd ask your friend if you could borrow $5, they would hand you cash from their Hello Kitty wallet, and perhaps the next day or the next week you would return the sum.

Now, the process of borrowing adult money is a little more complex.

A personal loan is when a bank or lender gives you money to use for anything you need, such as sudden emergencies or to pay off credit card debt. You pay it back in monthly amounts, plus a little extra as a fee for borrowing the cash. The latter is called interest.

All personal loans will come with interest, so it's nothing personal. But it sure can get complicated. Here are five things that affect your interest on a personal loan.

1. Interest rate-applied interest rates versus effective interest rates

When you look at information about a personal loan, you'll see two percentages. 

The lower percentage is the applied interest rate. This advertised rate is what lenders show to attract borrowers; it's the basic yearly cost of borrowing.

The higher rate is the effective interest rate (EIR), which shows the true cost of taking the loan. It includes all extra charges and fees, and accounts for compounding effects due to how often you make payments. So, while the advertised rate makes the loan look cheaper, the EIR helps you see the real amount you'll actually pay back.

When comparing personal loans, it's far more important to look at the EIR. But how do you calculate it? Good news: You don't really have to. In Singapore, lenders are legally required to publish the EIRs.

That doesn't mean that you should disregard everything else and make a decision based on just the EIR of course. Read on for more factors to consider.

2. Fees

While the interest rate reflects the cost of borrowing, it isn't the only cost. There are also a number of fees you have to cough up, including processing fees, annual fees, late payment charges, full repayment fees, and restructuring fees.

Of these, the first two are the most applicable; the others only apply if you are late with your payments or change the terms of your loan. We'll still go through all of them below.

Processing fees

A processing fee for a personal loan is a one-time charge by the lender to cover the administrative costs of setting up and approving the loan. It can be a one-off fixed amount or a percentage of your loan.

For example, the OCBC ExtraCash Loan charges a $100 processing fee (fixed amount), while the DBS Personal Loan's processing fee starts from one per cent of the approved loan amount.

There are also a good number of personal loans that don't charge any processing fees, including the Standard Chartered CashOne, Trust Instant Loan, and UOB Personal Loan. 

Annual fee

Just like how there are annual fees for credit cards, there are annual fees for personal loans. This is a yearly cost you pay to keep the loan active. Unfortunately, unlike credit card annual fees, that for personal loans usually can't be waived with a call to the bank.

On the other hand, not all personal loans charge an annual fee. For example, the CIMB Personal Loan comes with $0 annual fee charges, while the annual fee for the Standard Chartered CashOne is $199 for the first year. Subsequently, it's $0 unless you fail to make a minimum monthly payment by its due date-if you do, you'll be charged $50.

Late payment charges

You'll owe your lender money if you miss a loan payment or pay it late. It isn't just the one-time fee though — you'll also be charged late interest (a percentage).

Late fees are fixed extra charges you pay if you miss a loan payment by its due date. Comparatively, late interest charges are additional interest added for each day your payment is overdue, increasing the longer you wait to pay. These late interest charges tend to be very high rates, so avoid at all costs!

For example, if you're late for a repayment on your Standard Chartered CashOne loan, you'll have to pay a $100 fee on top of 29.9 per cent p.a. (0.082 per cent per day) additional interest.

There can also be one without the other-for example, GXS FlexiLoan doesn't charge a late fee but does charge late interest at a rate of 18 per cent.

Full repayment penalty

You'll see different terms for this fee, such as "early termination fee" or "early redemption fee". But they all refer to the same thing-the fee you pay if you decide to pay off the entire loan before the agreed end date.

This full repayment fee can be a percentage or a flat rate. For example, the early repayment fee is three per cent for the Trust Instant Loan, and a flat $250 for the DBS Personal Loan.

The fee can also be both a percentage and flat fee, in which case the higher value will apply. For example, the UOB Personal Loan charges $150 or three per cent of the remaining loan amount, whichever is higher, while the CIMB Personal Loan charges $250 or three per cent of the outstanding amount.

Restructuring fee

This is a charge for adjusting the loan term-shortening or extending how long you have to repay the money you borrowed. While the Trust Instant Loan has a $0 restructuring fee, this fee is S$50 per change for loans like the Standard Chartered CashOne.

As I mentioned at the beginning of this section, the late payment charges, full repayment penalties and restructuring fees, only apply under specific circumstances.

Comparatively, processing fees and annual fees (if the loan has them) will always apply even if you don't have any late payments or don't change your loan tenure.

For this reason, processing fees and annual fees will factor into the EIR calculated, while the others will not. However, the other types of fees are still worth considering; in the event that you do change the terms of your loan, these charges will add to the total cost of borrowing.

3. Loan term length

The loan term length (also known as the loan tenure) refers to how long you have to pay back the loan. It can affect the interest you pay in several ways.

Applied interest rate

Banks may give you higher or lower interest rates depending on the length of loan period you choose. For example, for the Citibank Quick Cash Loan, you get higher interest rates for shorter loan periods and lower interest rates for longer loan periods:

That said, in the example above you'll notice that the EIR works out to be the same for all. 

Total interest you pay

Even if the applied interest rate is the same for loans of two different loan periods, and even if there are no annual fees or processing fees, the EIR for both loans will differ.

The Standard Chartered CashOne loan is a good example. Excluding the annual fee, the interest rate for a $20,000 loan is 2.88 per cent p.a. (EIR 5.27 per cent p.a.) for a loan period of one year, and 2.88 per cent p.a. (EIR 5.43 per cent p.a.) for a loan period of five years.

You'll notice that the EIR increases. This is because with a 5-year loan, interest is applied over more periods, meaning you pay more in total interest (even though each individual payment is smaller). Your interest is compounding, which causes the EIR to rise slightly.

If you want to lower your cost of borrowing, you're better off with a shorter loan period. Not only will the compounding effects be lessened, but you'll also potentially pay fewer years' worth of annual fees.

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4. Your credit score

Although banks and lenders have their published interest rates online, the actual interest rate you'll get offered depends on other factors such as your credit score.

Your credit score shows how well you've handled money and payments in the past, based on payments like credit card bills and mortgage payments. Essentially, it's a number that shows how good you are at paying back money you borrow.

If you have a high score, lenders see you as responsible and may offer you a lower interest rate, meaning you pay less extra money back. If your score is low, lenders may think it's riskier to lend to you and might give you a higher interest rate, making the loan more expensive.

While your credit score affects the interest rate you're offered, don't forget that it also works the other way around-how timely you are with repaying a personal loan will also affect your credit score.

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5. Your income profile

While your credit score shows how well you've handled money and payments in the past, your current income profile reflects your ability to handle payments now.

Your income profile is basically how much money you make and how steady your job is. If you have a high income and a stable job, lenders trust that you can pay back the loan. They might offer you a lower interest rate, meaning you pay less extra money.

But if your income is lower or your job isn't steady, lenders might think it's riskier to lend to you-you're more likely to run into problems making the monthly repayments on time. They could charge a higher interest rate, which makes the loan more expensive.

What does this mean for you? If you want to get better interest rates, you'd want to avoid applying for a personal loan when you're in between jobs. It's best to apply after you've secured a full-time job.

However, don't worry if the nature of your work is commission-based or you're self-employed. Many banks, including Standard Chartered and DBS, will still consider you eligible for a personal loan as long as you meet an annual income requirement of $20,000.

6. Conclusion

We've discussed five factors that affect the interest you pay when you take a personal loan. Of the 5, the most important thing to understand is the difference between applied and effective interest rates-don't let the advertised rates fool you!

Once you understand what interest rates mean, look out for hidden fees. Banks don't go around readily advertising their processing fees (unless they are $0), so keep those eyes sharp.

Don't forget to consider your loan term length carefully. To reduce the total amount of interest you pay, take a shorter loan-but don't forget that this also means you pay higher repayments each month. Find a realistic balance you can work with to reduce your borrowing costs but also to ensure you don't end up paying late fees. 

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This article was first published in MoneySmart.