why are interest rates higher for people with low credit scores?

Question

I’m asking specifically about people in the U.S. looking to borrow from a lender.

In: 0

Answer 1

Imagine I plan to lend £100 to 100 people. I give out £10 000 so I would like at least £10 000 back at the end.

If I am confident that everyone will pay me back I can charge a very low interest rate, let’s say 1% (ignore inflation for now). So I get back £10 100.

But what happens if 2 of those people default and can’t pay me back? Now I only get back £9 898 and I have lost money.

So if I plan to lend to 100 risky people and assume that on average 2 people will default I would offer everybody say 3% interest. Then when 98 people pay me back I get £10 094, so still make a bit of profit.