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

Let’s have two groups of debtors, A and B. You know that 0% in group A are going to default, and all of them will pay you everything. But only 50% in group B are going to do that, the rest will default and not pay you anything.

At the end of the day, you need 10% yield, defaults priced in. Terms are lump repayment of principal+interests in one year.

For group A, you are going to simply offer 10% and meet your goal. But if you were to offer that to group B, you would lose half your money. From them, you have to demand 120% of interest to actually end up with your 10% target yield.

There is your 101 to payday loan economics.