Why Borrowers With Bad Credit Pay A Higher Interest Rates

By Pinyo, on May 12, 2008

As of yesterday, one of my loans at Lending Club became “31-120 days late” — 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).

Bad Credit No Credit

Photo by MBK via Flickr

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 main purpose of charging borrowers with bad credit rating a higher interest rate is to offset the higher default rate — not to 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. Please note, I am excluding predatory lenders such as payday loans in my argument above.

Let’s look at 2 scenarios (I am making some assumptions with these numbers):

“A” credit rating loans that pay 8%, and has an average default rate of 0%
“D” credit rating loans that pay 13%, and has an average default rate of 5%

Which one pays more? The “A” loans at 8% or the “D” loans at 13%. If you don’t factor in the default rate, it appears that the “D” loans pay more. But let’s do some math:

“A” loans = 8% interest rate – 0% default rate = 8% return on investment
“D” loans = 13% interest rate – 5% default rate = 8% return on investment

As you can see, both have the same return rate for lenders. Basically, the higher interest rate compensate 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 works to improve it. Two good tools I use for staying on top of my credit score are: myFICO and AnnualCreditReport.com (for credit score and credit report, respectively).

This post was featured in the Carnival of Peer-to-Peer Lending #9 hosted by Rate Ladder.

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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10 Comments

B Smith @ Wealth and Wisdom
May 12, 2008, 6:41

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.
Llama Money
May 12, 2008, 7:41

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.
Will
May 12, 2008, 7:58

I agree with the premise, but aren’t the scenarios a little oversimplified? In particular, in the examples you provided, the rates of return are SIGNIFICANTLY lower for the bad debt…
Aaron Stroud
May 12, 2008, 10:37

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?
Mrs. Micah
May 12, 2008, 11:31

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.
Pinyo
May 13, 2008, 4:49

@B Smith – Thank you. I don’t blame the people though. Our educational system is really lacking in this area and you can’t really count on parents to effectively teach personal finance to children.

@Llama – Exactly.

@Will – Yes, it’s oversimplified to get the point across. The article would be interesting if I add every little detail.

@Aaron – That’s a really philosophical question. I pondered on it for a while and I really can’t come up with a good answer. However, I disagree with your statement because certain types of lending allow borrowers to achieve certain financial goals that would be unattainable without borrowing — i.e., starting most businesses, buying a home, go to school, etc.

@Mrs. Micah – Thanks. I think that’s a good policy. Although the number looks nice when you can push interest rate to 13% or more, I think the result is the same with lending to borrowers with good credit — just less drama.
Aaron Stroud
May 13, 2008, 10:21

Pinyo, thanks for the honest answer. I think your difficulty drawing the line between “fair” and “predatory” is something we should all keep in mind (especially the gov’t).

Regarding debt, I’m not a hardliner like Dave. Although I’d prefer not to be in debt (I have no problem with our student loans that are locked in the 3-4% range), I recognize that people’s comfort levels differ and that sometimes you can end up richer by going into debt (college, medical treatment for your kids, etc).
Make Friends, Earn Money
May 13, 2008, 12:06

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 are set up in poorer areas and charge a fraction of the interest of banks and other financial organisations have a tiny number of people who default on loans and yet they deal with some of the people with the worst credit ratings. Why is this? Because repayments are more manageable and achievable unlike greedy banks.

I’m not anti profit at all, indeed it’s important for future investment, but I am anti extortion, and in some countries this would be a criminal offense.
Pinyo
May 14, 2008, 4:21

@Aaron – No problem. In the end, I think the definition will vary depending on the individual.

@Make Friend – Perhaps some sort of progressive interest rate based on the current payment history would be a fairer system. Say your credit score starts you at 20% interest rate. As you pay down you debt on time, your interest rate is progressively adjusted down as well.

Of course, the scenario is Utopian in nature, so it will never get done.
Ron@TheWisdomJournal
May 14, 2008, 5:46

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!

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