ElI5: What is the financial logic behind charging higher interest on loans for people with low credit scores? Doesn’t increasing the price like that make low credit individuals even less likely to repay the loan?

Question

ElI5: What is the financial logic behind charging higher interest on loans for people with low credit scores? Doesn’t increasing the price like that make low credit individuals even less likely to repay the loan?

In: Economics

Answer 1

The key to understanding this is to not think in terms of individuals, but in groups of people.

Say you have two groups of people:

1. A group of 1,000 people with a “fair” score of 630-689
2. A group of 1,000 people with an “excellent” score of 720-850

([ratings from Nerdwallet](https://www.nerdwallet.com/article/finance/what-is-a-good-credit-score))

If the “fair” group are charged 12% interest for an auto loan, while the “excellent” group are charged 6% for the same loan, the bank will collect the same total interest on the book of loans, even if half of the “fair” group default.

Basically, the risk of default is “priced into” the loan for everyone in that credit score group. When you have poor credit, the times you do actually make good on the loan, you’re actually paying to prop up others in your same credit group.

This is why it’s so important to maintain your credit score and not let it slip.