How do you calculate interest rate on a personal loan?

How you go about calculating interest on your personal loan depends on several factors. Personal loans are an incredibly versatile loan type with a wide variety of interest rates depending on the lender, the borrower’s credit score, and the loan terms. How you calculate the total amount of interest you will pay will also depend on what type of interest your loan has – a fixed or variable interest rate.

You might wonder why exactly your credit score has such a big impact on what interest rate you can be approved for when applying for personal loans. Gaining a better understanding of how credit scores work and what they are meant to represent might be helpful. Lenders rely so heavily on borrowers’ credit scores to approve them for loans and determine the interest rates they will charge because they are meant to represent an individual’s overall financial responsibility. 

The FICO credit score, created by the Fair Isaac Corporation, takes the information included on your credit report and breaks it down into a useful scoring model to make a simple three-digit number that can represent your creditworthiness. The information included in the calculation of your credit score goes like this:

  • Payment History → 35%
  • Amounts in Debt Owed → 30% 
  • Age of Your Credit History → 15% 
  • New Credit Inquiries → 10% 
  • Credit Mix → 10% 

While you might feel like your credit score does not fully represent your reliability as a borrower, there is no other measurement that lenders have, so it is a vital tool for them to protect themself from high-risk business decisions.

Once you know what your interest rate is going to be, you will need to determine whether you have a fixed-interest loan or a loan with a variable interest rate. A fixed-rate personal loan has its interest rate locked in from the start of the loan. It is simple to calculate the total interest you will pay for the loan because the interest rate does not change month to month. 

Variable interest rates are not quite as straightforward. Variable-rate loans have interest rates that change throughout the life of the loan as the index rate changes. The index rate used by variable-rate loans increases or decreases depending on the market conditions while you’re paying off your loan. It’s important to know what kind of interest rate you have so you can properly calculate how much you may need to pay when repaying your loan.

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