Why do interest rates on loans vary so widely? You purchase a car with a loan, you pay interest. You purchase a TV with your credit card and don’t pay it off in full the next month, you pay interest. We all know that. But why is the auto loan interest charged by your neighborhood credit union only 5 percent APR while the interest on your credit card purchase is 15 percent?
Interest rates vary for many different reasons, but consumer loans vary for two primary reasons – the borrower’s credit rating and the type of loan.
The rates cited above are only estimates since they could be higher or lower depending on many different factors, but a main factor is your FICO score, which was discussed in a previous blog. Basically, a higher FICO score (e.g., 750) means the borrower has a positive credit history and is considered a lower risk borrower, while a lower score (e.g., 650) means he or she probably has a spotty record and is a higher risk. Higher the risk, higher the interest.
Secured Versus Unsecured Loan
Another key factor that determines the interest rate is whether it is a “secured” installment loan or an “unsecured” revolving loan. An installment loan is a loan that is repaid over time with a set number of specific payments such as, for instance, an auto loan paid back at $300 a month over 60 months. When you borrow money to buy a car, the so-called pink slip that shows ownership is held by the lender as collateral until the loan is paid off. If the borrower can’t or doesn’t pay off the loan, the lender takes full ownership of the car and can then sell it to cover the loss from nonpayment.
But even in the case of an auto loan, the interest rates can vary depending on the borrower’s credit worthiness, length and amount of the loan.
In the case of a revolving loan, also called a revolving line of credit, the borrower can continuously take out loans of varying amounts with the monthly payments based on how much the borrower owes. While a credit card is probably the most common form of a revolving line of credit for consumers, it’s also common for businesses to have lines of credit for various purposes such as payroll.
Credit Card Purchases are Loans
When you as a consumer make a purchase with a credit card, as opposed to a debit card, you are in fact taking out a loan. As long as you consistently make payments required by your credit card issuer, such as your credit union, and you stay under the pre-set credit limit, you can continue to make purchases with the same credit card for as long as you have it.
Because credit card purchases are unsecured, so-called “uncollateralized” loans, the interest rates are understandably higher – in some cases much higher – than a secured loan. If the cardholder purchases clothes with his or her credit card and doesn’t make required payments, the card issuer would not repossess the clothes as collateral since they have no real value.
One Final Thought
One final thought about interest rates. While rates on larger items such as auto loans and home mortgages are relatively comparable and steady from one lender to another, give or take a percentage point, credit card rates are another matter. It pays to check out different credit cards, the interest rates for which can range from 12.5 to 25.5 percent for variable rate card, depending of course on the cardholder’s credit history.