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
The interest rate is higher because there’s a greater chance that the loan won’t be repaid and/or won’t be repaid on time. If the lender wants to make 5% over the course of a year, but thinks there’s a 10% chance that you’re going to default, then you’re going to get charged at least 17%. ( 90% x 1.17 = 1.05 ish).
And, in fact it’s worse than that — if the lender has very safe people who he could lend to at 5%, why would he decide to lend to somebody with poor credit if, on average, he’s only going to end up in the same position as he would if he lent to very safe people? So, he’s not going to lend at 17% — instead, those people may get 20% or 25% interest rates. [There’s some complicated math to figure out the real final percentage, but this is ELI5.]
You’re right that the fact of a higher interest rate means a higher rate of default. That’s accounted for in the rate that the lender will charge. But, ALSO, if you’re lending money to somebody who has some debt at 10%, and you’re at 17%, then chances are that he’s going to pay you first before the 10% guy.
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