Why Borrowers with Bad Credit Pay a Higher Interest Rates

Why Borrowers with Bad Credit Pay a Higher Interest Rates

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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.

14 thoughts on “Why Borrowers with Bad Credit Pay a Higher Interest Rates”

  1. 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.

  2. 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.

  3. 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?

  4. 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.

  5. @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.

  6. 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).

  7. 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.

  8. 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!

  9. @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.

  10. 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.

    • That is not correct at all. The reason they charge higher rates to people with worse credit all has to do with risk. Loans of all types have relatively similar ELGD (expected loss given default) over the maturity of the loan. The PD is what changes from loan to loan. With a lower credit score, a borrower poses a higher risk to the bank. Higher risk = a higher possible loss. The PD increases so the total money needed to be set aside into ALLL (allowance for loan and lease losses) increases. The banks need to be compensated for all this extra risk they are taking.

  11. 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?! 🙂 America = home of the double standards.

  12. 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.

  13. 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 because my payments would be lower so on. I understand the risk factor for lenders but why not make it where the interest rate is high until the principal loan (the original amount the lender let you borrow) gets their money back and then bring the interest rate way down to something more doable. Why!? Because they do want to keep us down and make us large on our payments and charge more for large payments and hey more money in the end! I can’t stand credit ratings, I have been trying to work on mine forever, just to keep getting slammed with high interest rates, more money to pay back!

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