It is tempting to think of a loan rate as a price tag: the lender decides it, and that is that. In practice it behaves more like a recipe, with several ingredients stacked together. Understanding the ingredients makes it easier to see why your offer looks the way it does, and which parts you can influence.
The layers of a rate
Lenders do not publish their exact methods, and each one is different, so treat this as a simplified model. Broadly, the rate has to cover four things.
- The cost of funds. A lender borrows money itself, from depositors or wholesale markets, and pays interest on it. Whatever it pays becomes the floor for what it must charge.
- Running costs. Staff, systems, assessing applications, collecting repayments and complying with regulation all cost money.
- A risk allowance. Some borrowers will fall behind, and a small share will not repay in full. Lenders add an allowance to the rate across their loans to absorb those losses.
- A margin. After the first three, there is something left to keep as profit and to hold as a buffer.
Here is a purely hypothetical stack to show the idea: 5.0% funding, 1.0% running costs, 1.5% risk allowance and 1.0% margin gives an 8.5% rate. Those numbers are invented for explanation and are not a description of any real lender.
Where you come in
The first two layers are mostly the same for everyone. The third, the risk allowance, is where your own details change the answer. A lender is trying to estimate how likely it is to be repaid in full and on time, and how much it could recover if it is not.
Things that tend to affect that estimate include:
- whether the loan is secured against an asset and what that asset is worth,
- your repayment history and any defaults on your credit file,
- the size of your deposit or equity,
- your income relative to your expenses and existing debts,
- the length of the term.
You can read more about how these factors interact in our guide to what affects your rate.
What a higher risk allowance costs in dollars
Suppose two borrowers each want $25,000 over five years. For the first, the lender's model produces an illustrative 8.5% rate. For the second, who has a thinner credit history and no deposit, the rate comes out at 10.5%, two points higher because the risk allowance is larger.
| 8.5% | 10.5% | |
|---|---|---|
| Monthly repayment | $512.91 | $537.35 |
| Total interest | $5,774.80 | $7,240.85 |
That is $24.44 more a month, and $1,466.05 more over the term for the same amount of money. Neither borrower is "wrong"; the lender has simply priced a different level of uncertainty.
Why rates are not perfectly fair or perfectly logical
Rates also reflect the lender's strategy. A lender trying to grow in a segment may be sharper on price; one that is cautious about a type of asset may be more expensive. This is why two lenders can look at the same borrower and quote different rates.
It also means a single rejection or a high quote is not a verdict on you. It is one lender's judgement on one day.
Practical takeaways
- Shop around within reason. Different lenders weigh risk differently. Compare comparison rates and fees, not just the headline.
- Reduce the risk the lender sees. A bigger deposit, a clean repayment record and accurate documents can all help.
- Ask what is driving the rate. A good broker or lender should be able to explain why an offer sits where it does.
- Check your credit file for errors before you apply. MoneySmart has a guide on how.
The bottom line
Your interest rate is a layered price. The bottom layers are about the lender; the risk layer is partly about you. Knowing which is which helps you focus on the things you can actually change.
This article is general information with illustrative figures. It is not advice or an offer of credit.
