I’m asking specifically about people in the U.S. looking to borrow from a lender.
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More risk.
A more risky borrower is more likely to end up unable to pay back borrowed funds. The bank lending those funds charges a higher interest rate as compensation for that higher risk of default
Higher risk.
Lenders charge interest as a hedge against inflation, but *also* as a cushion in case payments aren’t made. If you have bad credit, you’re more likely to miss payments, and as such need to pay a higher rate.
If you’re a safe bet and know you’ll make every payment, they’re okay with “small profit but guaranteed profit.”
Think about it like this more risk more reward…for whoever you are borrowing money from. If you have a low(risky) credit score, you are going to be charged more interest so the bank can make more money on you for taking the risk on someone who doesn’t have a good track record of paying bills on time.
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.
Because banks have the power to do so. Poor people have less options for money, so are exploitable. The banks claim there is additional “risk”. But it comes down to that banks can make more money be charging more, and since they can they do.
I understand the reason but also think it’s f’ed up. I think the system is designed to keep people in debt with how credit rating is determined. If someone is determined to have too much debt it lowers their score. So then if they try to get a loan to consolidate the debt at a lower rate to make it easier to pay off they don’t qualify due to having too much debt. Doesn’t matter if they haven’t had any late payments or consistently paid all their bills. So then they are stuck in the cycle of trying to play catch up.
Your friend David borrows $20-50 here and there because he keeps forgetting his wallet at home. Of all the 15 times he’s borrowed money, he always pays you back the very next time you see him. You even loaned him $500 once and he paid it back before your rent was due without having to be asked.
Your friend Jason borrows money at about the same rate, but you have to remind him over and over again that he owes you money before he’ll pay you back. You eventually get it back, but it’s a hassle.
Your friend Barb has borrowed money a few times, but she never pays you back. You have to ask her over and over to get anything, and even then, she begs poverty and gives you back only half or less of what she owes.
Your friend Susan has never borrowed money at all.
How likely are you to loan $20 to David, Jason, Barb, and Susan? What about $500? David’s a low risk. You’d probably loan him $20 with no interest. You kinda need the $500 yourself, so you might charge him $520 to borrow the $500, but you’d be reasonably certain that David would pay you back quickly.
Jason, on the other hand is a higher risk. Sure, he always pays you back, but he’s always late. This is a bit of a problem for you because you also have uses for that cash. You want to give him some incentive to pay you back, so you tell him that you’ll loan him $20, but he’s going to owe you $25 if he doesn’t pay you back before the end of the month. For the $500, you might not even loan it to him, but if he agrees to pay you back $700, you might be willing.
Barb though, you’re not going to loan any money unless you can just do without it yourself. Maybe you’re willing to loan her $10, but $20 is pushing it. There’s no way that you’d trust her with $500 though.
Susan’s a different story. You don’t know much about her. Is she like David or Barb? So you might treat her a bit like Jason until you know how she’ll pay you back.
Because they don’t really want to loan someone with a low credit score any money because they’ve proven that they are a credit risk.
A low credit score is an indicator that you are less likely to be able to pay back the loan, which means they are going to lose money by loaning you some.
So, in order to make their money, they want to first off discourage you from taking a loan in the first place. Secondly, if you’re going to go through with taking the loan, they want to get their money back as soon as possible before you default on the loan.
Think of it from lenders perspective. You are not running a charity, you want to get paid for lending money. So interests. But how much and who do you lend to? That depends on how likely your perspective borrowers are to pay your money back, because there is always a chance you don’t actually get your money back. So a riskier borrower has to promise you higher interests for you to consider lending them. Credit score is a estimate of that risk.
Very uncommon but a lower credit score could have a better interest rate. The scores would be rather close.
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