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
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.
If you think someone is going to default you want to charge more interest to make more money back before they do.
If someone is less likely to default you’ll make money over the whole term of the loan
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.
A loan is essentially a service that you’re paying someone to provide (i.e. you loan me $100, I return the money and pay you an extra $20 by a certain date). If you’ve previously failed to live up to your end of such a deal, then there’s going to be less people willing to make such loans in the future, and the ones who are can charge more money since they’re going to be more scarce
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You charge them a higher interest because there is a greater risk they default, and you have the costs associated with repossessing the asset and disposing of it — there are real costs associated with locating a car to repossess and re-sell, or foreclosing on a piece of real estate.
Or you want to collect as much interest up front in case they default and you have to write off their bad debts, say in the case of non-secured debt like credit cards.
Even if they don’t default, having to spend more man hours tracking down late payments and such is an added expense the higher interest charges help cover.
People with low credit scores are already more likely to not be able to pay back a loan. That’s how they got the low score after all.
From the lenders perspective, not giving them a loan at all is the best course of action. But if you’re going to loan them money, getting as much as possible back from them before they default on their loan and you then having to sell that loan for pennies on the dollar, is better than nothing.
You also want to discourage them from taking out loans unless it’s really really necessary. There are ways to increase your credit score that don’t require taking out a loan. Something like a Secured Credit Card. So if you have a low score, you should be looking at something like that to increase your score and prove that you aren’t a high risk.
The other thing to remember is that most loans have collateral…a house, a car, etc. So if someone defaults on the loan, the bank can take possession of the collateral.
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.
Interest is the monthly cost to buy a loan. Businesses charge more per month if you’re unlikely to finish paying for the product they sold you.
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