One of my loans at Lending Club became “31-120 days late” yesterday. This means the borrower is not making his monthly payment, and I could end up losing that money. Since I have 20 active loans, this represents a 5% loss if the loan should default. Curious, I dug a little deeper, and as anticipated, it was the one I made to a low credit rating borrower (credit rating D2). At first, it doesn’t seem fair that borrowers with the least money to spend have to pay higher interest rates. Wouldn’t it make sense for them to pay less so that they can afford to pay back? Well, that sounds good from the borrowers’ perspective, but when you borrow, you play by the lender’s rules.
To lenders, it is all about the return on investment. The primary purpose of charging bad credit borrowers a higher interest rate is to make up for the higher default rate. It is not to purposefully make more money and beat down on these borrowers. However, it does happen to a small degree since borrowers with bad credit have fewer options and are more vulnerable.
Comparing Borrower with Good Credit vs. Bad
Let’s look at two lending portfolios using a simple 1-year non-compounding interest loan and assuming default happens immediately. In reality, interest would be compounded, and payment amortized over three years, and defaults can happen any time during the life of the loan.
- “A” credit rating loans that pay 6%, and has an average default rate of 1%
- “D” credit rating loans that pay 12%, and has an average default rate of 10%
Which one pays the investor more? The “A” loans at 6% or the “D” loans at 12%. If you don’t factor in the default rate, it appears that the “D” loans pay more. Now assume you made 100 loans at $25 each:
- “A” loans = Invested $2,500 and 99 good loans return $2,624 for a ROI of 5%
- “D” loans = Invested $2,500 and 90 good loans return $2,520 for a ROI of 0.8%
As you can see, the bad loans portfolio carries a much higher risk for lenders, which is typical. The higher interest rate compensates for the default rate and other related expenses when lending to high-risk borrowers.
This is why it’s essential to monitor your credit score and continually work to improve your credit. Two useful tools I use for staying on top of my credit score are myFICO and AnnualCreditReport.com (for credit score and credit report, respectively).
Bottom Line
Borrowers with bad credit pay a higher interest rate because they are more likely to default on their loans. To compensate for this greater risk, lenders charge bad credit borrowers higher interest rates to make up for the higher risk of loss.
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Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a RealtorĀ® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and RealtorĀ®.
Nice illustration. That’s why, if I ever choose to go P2P, I plan to stick with people who have good credit. But I’m still waiting for things to sort themselves out. Then we’ll see.
Good post on loan interest rates 101. While the math was simplistic, it explained it clearly.
I’d say it was unnecessary but I’ve talked to enough people that didn’t get it. I always find it amazing when people don’t understand personal finance or business basics. What seems like common sense is misunderstood by most people.
Absolutely correct. When a lender finances someone with awful credit, they are taking on a huge, huge risk. After all, that borrower has a solid history of never paying anyone on time / at all. If I were said lender, then you’re daggone right I’ll want a sky-high rate just to cover my risk. Greater risk should always mean the potential for greater rewards.
Pinyo, how do you draw the line between “predatory lenders such as payday loans” and reasonable rates charged to poor credit borrowers. All of the lending situations involve freely entered transactions.
In fact, one might convincingly argue that lending for a profit is always predatory. Afterall, wouldn’t the borrower be better off if they didn’t have to compensate the lender?
I think this is a very complex issue, but financial institutions could help address the issue of bad debt simply by reducing the amount of interest that they charge. The problem here is greed and the pursuit of profit at the cost of long term social investment. Whilst clearly there are some individuals who will always abuse the system and ruin it for the rest of us, i am convinced that the majority of people get into debt because they are unable, not unwilling to keep up with spiraling interest payments. It is interesting that credit unions or co-operatives which… Read more »
This is a great post. People tend to think that lenders are unfair to borrowers with poor credit. The reason they have poor credit is because at some point, they were unfair to other lenders!
all the banks want is to charge high interest so that the loan payments are late or they can’t pay so they can make more money by charging collection fees and any other fees they can think of. and then sell the property for a nice profit to them while screwing the borrower.if you have perfect credit you get 2% bad credit you get 12%, the rate should be the same no matter your credit. if those with bad credit got the same rate as those with perfect credit they would be better able to repay it, but the banks… Read more »
Maybe I’m missing something? People with bad credit typically get a 18% interest rate vs. a 6% rate. IMO this is the problem with our economy (GREED) The interest rate should be fixed it doesn’t make sense to charge someone that has less more. Or is that only a rule when trying to tax wealthy people more?! š America = home of the double standards.
I think the calculation for loan “D” is wrong. Shouldn’t the total return in dollars be equal to (2500*0.9)(1+0.12)?
The resulting answer is $2520, which is lower than the final return on loan A, which is equal to $2623.5 exactly.
This is the opposite of the idea that the return on higher risk investment is larger.
I am quite confused, so it would be great if anyone could help me out.
I don’t usually post reply’s but I think this one warrants one. I, myself am an adult male in his late 20’s. I have a credit score of just above 600. It is so difficult to get it any higher because all my loans have interest rates above 20%and some almost 30%.I do not default on them but sometimes I am late because of unexpected expenses, ie car repairs, house expenses etc. Anyways, I always end up paying my payments but my credit always takes a hit. I wouldn’t be in this situation if my interest rates weren’t so high… Read more »
our credit system in north america is completely corrupt because its been privatized rather then it be regulated by the government – makes no sense to me why a lender would want high risk borrowers to pay more then low risk as wouldn’t you want to ensure the ROI?