Why Borrowers with Bad Credit Pay a Higher Interest Rates

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.

Comparing Borrower with Good Credit vs Bad

Let’s look at 2 lending portfolios using a very simple 1-year non-compounding interest loan and assuming default happens immediately. In reality, interest would be compounded and payment amortized over 3 years, and defaults can happen any time during the life of the loan.

  1. “A” credit rating loans that pay 6%, and has an average default rate of 1%
  2. “D” credit rating loans that pay 12%, and has an average default rate of 10%

Which one pays 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 make 100 loans at $25 each:

  1. “A” loans = Invested $2,500 and 99 good loans return $2,624 for a ROI of 5%
  2. “D” loans = Invested $2,500 and 90 good loans return $2,660 for a ROI of 6%

As you can see, the bad loans portfolio have a higher return rate for lenders, which is typical. 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). Lastly, here is an article I wrote on how to improve your credit score.

About the Author

By , on May 12, 2008
Pinyo
Pinyo is the owner of Moolanomy Personal Finance. He is a licensed Realtor specializing in residential homes in the Northern Virginia area. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, and financial literacy author.

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Leave Your Comment (10 Comments)

  1. dwight says:

    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 don’t want that. all it is is plain old greed.

  2. Pinyo says:

    @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.

  3. Ron says:

    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!

  4. Jonathan says:

    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.

  5. Aaron Stroud says:

    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).

  6. Pinyo says:

    @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.

    @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.

  7. Mrs. Micah says:

    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.

  8. Llama Money says:

    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.

  9. Aaron Stroud says:

    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?

  10. B Smith says:

    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.

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