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).
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.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® 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 Realtor®.