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 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.
Since people with bad credit are much more likely to default, the people with bad credit who don’t default have to pay extra to make up for the defaulters. If not, then loaning money to people with bad credit would lose companies money, and they just wouldn’t ever loan money in those situations.
people with low credit scores are less likely to pay you back to start with regardless of the interest rate. people with less than 600 scores default ~30% of the time, those with north of 700 credit scores borderline never default.
higher interest allows the creditor to recoup their loan faster from higher risk populations. you essentially pay a penalty for your low credit and people like you. i have to collect the full loan amount of 1 in 3 people from the other 2 people in that category basically so that I’m not taking a loss.
Also, if you have a high credit score, you’re likely more fiscally responsible. You aren’t going to borrow money at high interest rates because you probably have other options. You’d explore other options that you probably have first. So. if a creditor wants their money, they have to be competitive with the other means they have of borrowing money. People with low credit scores don’t have those other options usually.
In addition to all of the excellent comments, the interest rate charged to people with poor credit scores is based on these factors, too:
* Even if you default, you probably won’t *instantly* default,
* if it’s a secured loan, the lender will recover *some more* of their money (eventually), and
* rate determinations are based on statistics (essentially, actuarial tables); they’ll lose money on some defaulted loans, but make it up on other loans that are paid back in full.
It is also supply and demand, higher interest rates also make the loan more expensive and lowers demand for it
Think of it the other way around. If not repaying your loans made your credit score worse, but your interest rate better, then why would anyone ever repay their loans?
Although the increased rate does cause more defaults, it only increases the default rate a little bit. The fact the customer has a low credit score indicates there is already a high likelihood of default. The credit score is the main factor in predicting the default rate. This factor much outweighs the increase caused by a higher interest rate.
If the lender already knows that 10 times as many loans are going to default when the customers have a low credit score, they need to increase the interest rate to make up for it. Otherwise, it is not worth it to even give out loans to these customers.
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