by Dave Czach
Why Bad Credit People Pay Higher Rates
Let's face it. People with credit problems pay higher rates for the same reason people pay higher auto insurance premiums - risk. Virtually everyone knows if you receive a traffic ticket, you get points on your driving record and an increase in your insurance premium. Why? Because the traffic ticket has created an emerging pattern of risk. If you got one traffic ticket, the chances of receiving another one are now greater than when you had no tickets. Therefore, there is a greater likelihood of you filing a claim in the future. A speeding ticket can lead to accidents, property damage or even vehicular manslaughter. All of which pose a real risk of the insurance company paying a claim. The more claims the company pays, the less money they have to pay other claims and make sound investments to pay future claims.
The credit world is similar. If you pay your bills late, your credit score decreases and the interest rate on your next financing increases. Why? Because the late payment has created an emerging pattern of risk. Whatever the reason for your late payment is the basis for future late payments. For example, if you have been living beyond your means buying items on credit because you can't afford to pay cash, this causes larger monthly payments. When it gets to the point of causing a late payment, it's most likely to continue because you have demonstrated you don't have enough money to pay your bills. Hence, there is a greater chance of frequent or severe delinquency in the future. But the real world credit market differs from the insurance comparison due to one more factor - opportunity.
Lenders are not required to loan you money. Afterall, from their perspective, they are comparable to annuity investors. That's right - investors. Suppose you were buying an annuity that would pay you monthly for 30 years. You could choose Annuity X that pays in full and on time every month with a rating of "A." Or you could select Annuity Z that sometimes pays late and sometimes misses a payment completely with a rating of "B." As an investor who may not get paid entirely by choosing Annuity Z, it's only fair that you require a higher yield - or return on investment - in exchange for accepting the extra risk of losing your money. If the investor is not comfortable with the added risk, they could exercise their right of opportunity and choose Annuity X. It pays a lower yield. But they are relatively assured they will receive all their money in full and on time.
Now let's flip the perspective back to lending. In the above investor example, replace the words investor with lender, yield with interest rate and annuity with mortgage loan. Now we see a more clear picture. Borrower A who pays in full and on time every month is a low risk and receives the lower interest rate because the lender is relatively assured of receiving their money. Borrower B is a much higher risk and pays the higher interest rate because the lender is accepting the chance they may not be repaid all their money.
Now let's take it a step further. Imagine you had $100,000 to invest and had to choose between Borrower A and Borrower B. Which one would get your money? Moreover, why not loan $100,000 to Borrower B at the same rate as Borrower A? Afterall, "B" borrowers often claim they no longer have the same problems that caused their delinquency. "They turned a new leaf." Yet, they haven't proven it. They still pay their bills late. Would you take them at their word and give them the same rate as Borrower A? A true investor would not.
In conclusion, it's as simple as risk and opportunity. Contrary to the divisive manipulation of data from the media and organizations with an agenda, people with credit problems pay higher rates because they are a higher investment risk - period. It has nothing to do with race, religion, ethnicity or national origin. From my experience in the mortgage business, loan officers only care about one color - green!
© 2003 SonicPoint.com
Dave Czach has 12 years experience in the mortgage business plus a Bachelor's Degree in Real Estate.
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