Typical to the UK. Why is it that banks charge higher interest to those that are financially at risk, surely those that are financially viable should pay higher rates, lower income earners would benefit from lower rates.

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Thank God for magnetism.

Because if the borrower is a higher risk borrower, there is a greater risk the bank won't get its money back. So as such, in order to take that risk, they make the interest rate higher so the potential return is greater. Risk is a legitimate parameter in business calculations. It is factored into the estimate return on investment. A greater risk leads a greater prize to be justifiable and in this case it is in the form of higher interest rates.

It's like during hydrocarbon exploration. We might survey an area and find what we think could be a 3 billion barrel field, but various factors lead us to doubt if the reservoir is good. We might assign a risk of 0.3. So our risked reserves are 900 million bbls. Another field might be a piddly 1 billion barrel field, but it looks very likely there's something to be had there. The risk is 0.9 and so the risked reserves are also 900 million barrels.

Typical in the USA too. A "payday loan" (don't know if these exist in the UK) is a good example: Customer, usually lower income and with little or no credit history, borrows $200, for example, to get them to their next payday. This $200 typically costs the customer $40 for the two weeks--an interest rate of over 500% APR! Credit-cards geared to the lower income brackets also typically have much higher interest rates, say 25-30% as opposed to 8-9%. Call it capitalism, or maybe plain old extortion...lenders that serve the lower-income market know their customers have nowhere else to turn.

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"WARNING: Being launched into space is hazardous."--Lonewulf

Triplebrick is no longer birdable. It was fun while it lasted.

"N'oubliez pas: l'ours n'est pas un nounours!"--Nounours de Salmonberry

Surely then as a banker you would charge a higher rate to those that can afford it minimising risk with greater return as opposed to those that cant. Surely that would be more logical ?

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Thank God for magnetism.

Let's not forget that higher income doesn't always equal good credit risk. Plenty of individuals make a lot of money and spend a lot of money too. The rate is driven in large part by the borrowers repayment history - not by their current income. Qualifying for the loan in the first place can be driven by income - but for smaller loans, they don't even look at that.

If people have proven themselves to repay debt in a timely fashion, they'll get better interest rates. People that have a history of delinquency and various other negative items on their report won't get very good rates.

When I was in college working for peanuts and renting an apartment with two other people just to make it affordable - I always received the best rate available on those occasions that I did borrow money. I never missed a payment and I never borrowed more than I could afford to repay (and yes, I did account for potential lapses in income when considering whether or not the loan was affordable).

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Spock Jenkins of the Vulcan Jenkins'.

Typical to the UK. Why is it that banks charge higher interest to those that are financially at risk, surely those that are financially viable should pay higher rates, lower income earners would benefit from lower rates.

Banks are not in the charity business. They make loans as a means of earning income. As others have pointed out above, if you have a good history of paying the loans on time then you are considered a low risk borrower. That means you'll qualify for a lower interest rate than someone who is a higher risk borrower.

In general terms, there are two broad types of loans - secured and unsecured. Secured loans are provided for things that have value and can be repossessed if the borrower defaults. These are typically things like mortgages and auto loans. Unsecured loans are typically things like credit cards where the lender is left holding the bag if the borrower defaults. People with a bad credit history are more likely to default, so they have to pay higher interest rates to justify the higher risk.

Another reason why do banks charge lower interest rates to low risk borrowers is that they're competing for the business. Banks that tried to charge higher rates to those who are low risk borrowers will lose their business.

Last year Oregon passed a law limiting interest rates to mere usury; within two months every one of the 'payday loan' joints in my smallish town (ca. 30,000) was closed. There had been seven or eight.

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If they can get you asking the wrong questions, they don't have to worry about the answers.

I was going to add that as well. If I can walk in to any bank in the area and be approved for a loan - why would I allow them to charge me a high rate? I'll just go next door. Banks know this and will typically make a decent offer up front so they'll get your business. This will also open up the possibility of your trusting them with your deposits - as individuals that are good credit risks are typically able to bring deposits to the bank as well. They are also likely investors and have retirement savings that could come as many banks in the US also handle brokerage and insurance services as well.

Poor credit risks don't typically have much in the way of savings to compete over.

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Spock Jenkins of the Vulcan Jenkins'.

So, at risk means that you have to pay more, though you can ill afford to. If you can afford it you pay less. Wheres the logic ?

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Thank God for magnetism.

That's a great law. While I agree with pricing adjusted for risk (otherwise banks simply wouldn't lend to high risk borrowers) - I am very much opposed to predatory lenders.

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Spock Jenkins of the Vulcan Jenkins'.

The logic is - if I'm not going to get repaid - I won't make the loan at all. Or, I can charge a premium for assuming this greater risk and that way, although more of these borrowers will likely default - the premium I'm able to gain on those that do repay will cover my losses.

Years ago, many individuals that ran into hard times simply couldn't get a loan at all. So which is worse? Decline everyone out of hand, or at least make an offer and charge for your willingness to assume the higher risk?

The other side of the coin is that if you can ill afford to repay - don't borrow the money.

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Spock Jenkins of the Vulcan Jenkins'.

Well, Sean's idea of charging higher interest to those who can afford it would work if you could make all lenders do it. But once even one lender decides to offer a lower rate to low-risk borrowers, the others will have to follow suit.

See, I wonder that, too. Mike mentioned the effective banning of those pay-day loan type places, but all that means is that the people who were using them now can't borrow money at all. Did that really help them?

Indeed.

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SeanF

"Ask to understand, but don't challenge unless you have the knowledge."--NEOWatcher

The contents of this post are ©2009 by SeanF and may not be copied or retransmitted in any form without the express written consent of SeanF

If there is a predatory lending line to be crossed - those are the businesses that crossed it. If people need to resort to those lenders - they really need to be seeking other kinds of help such as state aid or quitting a few bad habits. If it's simply a need to be late on a payment do to the timing of your payment - most lenders will negotiate with you. For example, if you get paid on the 15th and your bill is due the 10th. You typically don't get a negative mark on your credit report until you're 30 days past due. Many lenders will change the regular due date. Lenders don't want collateral - they want to be repaid. They will work with borrowers to make this happen.

These places sell a service that should not be necessary. But because it's so much easier than calling a creditor to negotiate - people use it. Walk in with nothing, walk out with cash. What could be easier?

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Spock Jenkins of the Vulcan Jenkins'.

Well, Sean's idea of charging higher interest to those who can afford it would work if you could make all lenders do it. But once even one lender decides to offer a lower rate to low-risk borrowers, the others will have to follow suit.

The industry is very competitive. They want to maximize their profits, which means balancing the interest rates they charge (higher rates discourage potential customers) against risk. If one company decides to offer high-risk borrowers a significantly lower interest rate, they'll get a lot of new customers all right. However, the number of loan defaults they have will also be high. Odds are they won't be in that business for long.

So, at risk means that you have to pay more, though you can ill afford to. If you can afford it you pay less. Wheres the logic ?

Try turning it around - why should people who've behaved responsibly have to pay higher rates to subsidize people who have behaved poorly (financially)? Where's the logic of that other than envy?

Risk is a money maker.

Assigning risk isn't always quite logical.

For example:
Your electric bill is late. What do they do? Take on a late fee to 'penalize' you.

But obviously, if you had money, chances are you would have payed the electric bill on time and in full- not partially or late.
Adding to the cost doesn't seem very sensible...

The point is- People still end up, at some point, having to pay the bill including all penalties and fees. So with this monopoly, they are able to make their money plus a lot extra.

Yes, credit can sometimes determine risk. Anyone providing a billed service or a loan needs assurance that they will make profit as well as make their money back.
How else can they encourage proper payment, insure they will get their return and teach people responsibility? You cannot always collact collateral (Pawn shops) or take out a contract on the first born...

And people were willing to pay the higher interest rates for that ease of use. Why shouldn't they be allowed to?

Sean's idea is that instead of making up for the defaulted loans by charging higher interest rates to the high-risk borrowers, they would make it up by charging higher interest rates to the low-risk borrowers. As long as they make up the loss somewhere, they could stay in business. But, as I said, that would only work if those low-risk borrowers can't get cheaper rates elsewhere.

Another very good point

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SeanF

"Ask to understand, but don't challenge unless you have the knowledge."--NEOWatcher

The contents of this post are ©2009 by SeanF and may not be copied or retransmitted in any form without the express written consent of SeanF

But, there's another problem with that: it provides an incentive to default on loans to get a lower rate.

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Quaeso quousque humi defixa tua mens erit? Nonne aspicis, quae in templa veneris?

In plain sight.

Let's exemplify:

Two lenders want to borrow £10,000.

One of them is a low risk borrower with a 99% chance of making his repayments without issue. He gets an interest rate of 10% for his trouble. The gross margin for the lender is £1,000. When risk is factored in, the return is £990.

The other is a high risk borrower with only a 60% chance of making his repayments without issue. He gets an interest rate of 15%. The gross margin for the lender is £1,500. But with risk, this becomes £900.

So in fact, despite the higher interest rate, the risk factor makes the return on investment of lending to the high risk borrower lower. Now imagine if the interest rate wasn't raised to compensate for the high risk. The lender might not feel it economical to lend at all.

I would say, "probably", or in other words "yes, in the long run". Usury is such a vile crime that there are fundie sects that adhere to the biblical prohibition against charging interest (one explained to me that this was the foot in the banking door for non-christians).
Same reason that illegal gambling is not allowed, or pyramid schemes, even though most participants are clamoring for more. If pyramid schemes were allowed, they'd be multiplying like microsoft.

It seems to be tradition that the general
public are donkeys to be ripped off by finance
people while being made to feel important. For
instance we have interest payments in
mortgages rolled up into annual sums added to
the mortgage. Does this not mean much extra
cash is extracted from the morgagee over the
lifetime of the mortgage. I understand
Australians were agitating for monthly
recalculations of payments some years ago.
Did they get it?

Another item sticks in the memory. In the
early nineties housing slump when many were
having to face reposession, a law firm
claimed that the wording of some mortgage
indemnity guarantees benefited the borrower.
The attitude of many finance journalists was
interesting as they became virtual mouthpieces
for lending institutions talking about
borrowers having to be "counseled out of
unrealistic expectations". But what was the
wording of these guarantees? Well no one found
out! A few people did take the lender to court
but when it came to disclosure, the lender
quickly settled out of court. So was the
lender extracting money for non existant
policies? The borrower should certainly see
the terms of anything they pay for. But as I
say, borrowers are by tradition just victims!

I would consider pyramid schemes to be closer to fraud, since they're basically promising something that can't be delivered, but it still boils down to protecting people from themselves. The reference to why "illegal gambling" is not allowed seems a bit circular since the only thing that separates "illegal gambling" from "legal gambling" is the fact that the former is not allowed.

At any rate, I just happened (seriously - complete coincidence) to come across this. Food for thought.

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SeanF

"Ask to understand, but don't challenge unless you have the knowledge."--NEOWatcher

The contents of this post are ©2009 by SeanF and may not be copied or retransmitted in any form without the express written consent of SeanF

Before the rise of the payday loan companies organized crime provided a similar service in many urban areas, except their rates weren't generally as high.

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If they can get you asking the wrong questions, they don't have to worry about the answers.

Before the rise of the payday loan companies organized crime provided a similar service in many urban areas, except their rates weren't generally as high.

Their rates may not have been as high as the payday loan places but their collection methods were harsh. If you fail to pay back a loan shark, you could end up with broken legs or worse. If you fail to pay back one of those payday loan places, nothing much will happen to you. The loss is just considered part of the cost of doing business.

Let's see. They borrowed money they didn't pay back. Spent the money and defaulted on the loan. Free money that they didn't have to spend from their own pocket. At 200%, no wonder the lender was profitable. 2 out of every 3 borrowers could default and they company would break even.

Was the loan reported on borrowers credit report? Since it was part of an experiment - they may have chosen not to report it. That being the case, use the proceeds of the free money to pay existing debt, improve your score and default on the one that doesn't count. No problem.

I suppose I'd need more information on the experiment to accept the results at face value.

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Spock Jenkins of the Vulcan Jenkins'.

The justification for banning the loans is that people are better off without them. The question of why they ended up better off with them is interesting, to be sure, but it undercuts the basis for banning them regardless.

Not quite. They were only four-month loans, at 200% annual, so only about two out of five could default to break even - and that's assuming zero overhead.

That I won't argue with.

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SeanF

"Ask to understand, but don't challenge unless you have the knowledge."--NEOWatcher

The contents of this post are ©2009 by SeanF and may not be copied or retransmitted in any form without the express written consent of SeanF

http://www.dartmouth.edu/~jzinman/Pa...cess_jun07.pdf

Above is a (pdf) link to the original paper SeanF referred to. It is about 0.6 bottles of aspirin long if you are not an expert in the area.

One of the things I noticed was that the study specifically controlled (if I understand it correctly) for comparisons between loans to persons getting normal procedural approval and those who 'just missed' the cutoff criteria being randomly reassessed. While this strikes me as a good procedure to minimize other variables in the population it would be helpful to know the actual distribution of loans in, say, my own state of Oregon. The link is below helpful

http://www.dfcs.oregon.gov/cf/fact_sheet.html


The way most places worked here, the applicant would get a check for the requested amount and give the loan company their own check (loan plus fees and interest) post-dated two weeks. If they couldn't pay it back it just rolled over. It also appears that some (I can't tell the percentage) of the payday advance places do cursory or no credit checks.

The latter point makes it hard to compare the South Africa study to the American payday loan practice. If the American establishments are basically accepting clients with poor or no credit ratings as a matter of course, any comparison is difficult if not impossible.

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If they can get you asking the wrong questions, they don't have to worry about the answers.

It's true, but that's the logic of capitalism. Suppose that you have just made something. Would you sell it to a rich person who offered you more money, or a poor person, who needed it less, but was willing to offer less? It's really the same issue.

And yes, it seems illogical in a sense, because housing is often considered to be a human right. So there is a solution to the problem you raise: safety nets. I don't know if the US has this, but many countries have government subsidies available for low income earners. Or public housing, for example.

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As above, so below

I know this will be difficult to believe, but banks are businesses trying to earn a profit, not charities.

Do you loan money to people with high credit risk at favorable rates?

The Morse paper (it's in the reference list of the paper you cite) addresses that at length, if any of the people here are willing to sully their elevated minds with something as sordid as evidence. I'm sure her findings have been or are being contested.

Perhaps they could try not borrowing.