If you’re like most people, you probably have several different types of loans open right now: a credit card, a mortgage, maybe even a student loan. You probably know that your credit score influences the rates you’re paying on these loans, but did you ever wonder why the interest on each one is so different?
It turns out that your credit score is only part of the equation when it comes to determining how much you’ll be charged in interest on a loan. If you’re wondering about the other factors involved, take a look at the details below.
Secured vs. unsecured: Why it matters for interest rates
To understand the most fundamental reason that credit card interest rates are so much higher than those of other loans, you have to familiarize yourself with the difference between secured and unsecured debts. This seemingly small distinction has a huge impact on a loan’s interest rate.
Simply put, a secured loan has collateral attached to it. This collateral is what provides “security” in the event that you default. Mortgages, for example, are secured loans – you take out a mortgage from your bank to buy your house, and your house serves as the collateral for the loan. If you don’t pay, the bank forecloses and can resell the collateral (the house) to recoup some of the losses it incurred from loaning you money.
In contrast, an unsecured loan – like a credit card – doesn’t have any collateral backing it. There is nothing that the bank can take back if you don’t pay your credit card bill. They can sue you for the money, but eventually it’s likely they’ll have to absorb the loss.
This is the essence of why credit cards carry a much higher interest rate than other types of loans – since the bank is taking on a huge risk by offering you unsecured credit, they need a way to hedge against potential losses. This comes in the form of high interest rates. But with secured debts, the risk of loss is much smaller for the bank because there’s something it can take away and resell if you fail to pay.
In short, with great risk comes higher interest rates, and credit cards are about as risky as it gets.
Nerd note: if you’re applying for a loan — secured or unsecured — and you have poor or limited credit, getting a cosigner with good credit will likely bring your interest rate down. This is because, in the event that you don’t pay on your loan, the bank knows that there’s someone with a good financial track record that they can go to for the money. This makes you a much less risky bet than if you were to try get the loan on your own, so your interest rate won’t be as high.
When Uncle Sam has your back
Now that you understand the difference between secured and unsecured loans, a question is probably looming in your mind: If unsecured debts carry higher interest rates, why are the rates on my student loans pretty low? After all, student loans aren’t secured by anything — shouldn’t their interest rates be sky high? The answer to this question brings up another important factor in determining a loan’s interest rate — the government’s role in the loan you’ve taken out.
Government-backed loans, as the name implies, are loans that the federal government has guaranteed will be partially or fully paid back to lenders. These types of loans include federal student loans and some types of mortgages, among several others.
The reason that the government backs up loans is simple: It wants to encourage people to borrow money for purchases that will have a positive long-term effect on the U.S. economy, such as homes and college educations. To do so, it agrees to guarantee the loans needed to finance these endeavors. If the borrower doesn’t pay, the bank will get some of its money back from Uncle Sam, which means that these loans are less risky for the bank to issue.
Once again, a lower risk level for the bank means lower interest rates for the borrower. When the government’s got your back, you’ll be paying less in interest, even if, like federal student loans, the borrowed money isn’t backed by collateral.
How to keep your interest rates as low as possible
Given how complicated it is for the bank to determine the interest rates on your loans, you might wonder if there’s any way to keep your rates down. Luckily, the Nerds have a few tips to keep your borrowing costs as low as possible, regardless of the type of loan you’re taking out:
- Get and keep a high credit score – again, this goes back to risk. If you have a high credit score, the bank looks at you as a less risky borrower and your interest rates will be lower.
- Take out government-backed loans whenever possible.
- Consider getting a cosigner
The takeaway: Although your credit score plays a role in the interest rate you’ll pay on a loan, it’s not the only factor. Secured and government-backed loans are always going to carry lower interest rates than risky loans like credit cards. However, there are steps you can take to keep your rates down, no matter what type of loan you’re interested in.
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