Banks use a risk-based pricing model to set interest rates for unsecured loans. These loans are unsecured, because the only guarantee the lender has that you'll repay them is the strength of your promise to pay as attested to by your signature. With this model, lenders view risk from a general and an individual perspective. Both perspectives contribute to interest rates that range from less than 10 percent to higher than 30 percent; these are generally higher than for secured loans.
Unsecured Loans Are Risky Business
Interest rates always address the level of risk a loan poses. They include a risk premium designed to compensate lenders for being willing to make risky loans.
All unsecured loans carry greater built-in risks than loans having a collateral guarantee. With a secured loan, the lender has the option to repossess and sell the property or item pledged as collateral if you default on the repayment terms of the loan. If you default on an unsecured loan, a lender can take legal action to recover the money, but this can be costly and time consuming. In addition, if you file for bankruptcy, secured creditors are paid first and often receive full payment, while most unsecured creditors receive only pennies on the dollar and sometimes recover nothing.
A borrower’s credit history also plays a major role in the interest rate offered. While a risk premium is always higher for unsecured loans, individual borrower characteristics can cause it to rise even higher. According to the Federal Reserve Bank of Minneapolis, the cutoff between higher and lower average interest rates is a credit score in the mid-600s. As evidence, the Fed cites statistics that one of every 21 borrowers with a credit score of 710 points will default on a loan, while one of every 11 borrowers with a credit score of 680 will default. The expectation of higher losses with lower credit scores increases the average interest rate.
What This Means for You
An interest rate calculation doesn’t rely solely on risk. The cost of credit also includes funding costs, which can increase or decrease according to the economic environment, operating costs, the bank’s profit margin and its willingness to assume risk. All of these cause interest rates to vary among lenders and fluctuate over time. This is one reason why managing your credit and comparison-shopping are vital to getting the best interest rate for your financial situation.