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

All else equal, yes, a higher interest rate increases risk of default. However, that increased risk of default is more than offset by the increase in interest. The value of the loan is determined by both the default risk and the interest rate. These two factors impact one another, but not proportionally with their impact on the return.

Basically, increasing the interest rate can raise the value of the loan more than the resultant increase in default risk decreases it.