Why Do Fast Loans Carry Such High Interest Rates?
Consumers who encounter a financial emergency often need fast loans to borrow money, but they typically need lenders to process their applications quickly. Cash-strapped borrowers may not have the ability to wait a week or more to receive the funds needed to repair the family car, pay for a spouse to visit a doctor or patch a roof that is leaking. Therefore, they turn to fast loans online or through a storefront. Despite their immediate need, many borrowers wonder why the interest rates on fast loans are so high.
Why Interest Rates on Fast Loans Are High
To understand why fast loans carry such high interest rates, it might be helpful to review how a typical bank determines the interest rates it will charge. The first thing to remember is that all lenders, including banks, credit unions and private lenders who make fast loans online, are in business to make a profit. Although there are various methods that can be used to determine an interest rate, many lenders use the cost-plus model.
As explained by the Federal Reserve Bank of Minneapolis, the cost-plus model is based on four factors.
• How much will it cost the lender to secure the funds for the loan? Whether the funds are overnight loans from another bank or obtained from deposits made by customers, there will be some type of expense to the lender.
• How much will the lender spend on operating costs to service the loan? These costs include processing the application and monthly payments, employee salaries and overhead costs such as utilities.
• How much profit does the lender need to earn to achieve a sufficient return on the capital loaned?
• How much does the lender charge as a risk premium? A risk premium is designed to offset the bank’s losses if the loan is not repaid. For people seeking fast loans with bad credit, this is usually a critical factor in determining interest rates.
To illustrate, suppose a lender offering fast loans online can borrow money at a 5-percent interest rate. Historically, the lender’s costs for servicing a loan average 2 percent of the amount loaned. The lender’s target profit is 1 percent. Without considering risk, the lender could offer a loan with an interest rate of 8 percent and still earn a profit. Once risks are evaluated, however, the interest rate will rise.
How Greater Risks Affect Interest Rates on Fast Loans
Borrowers are individuals with different circumstances, which has always made the risk premium a challenging factor for lenders to assess. To minimize their risks, lenders put mortgage applications through a process known as underwriting. During the underwriting process, the lender verifies the consumer’s employment history, income and down payment. The borrower’s debts will be evaluated to ensure that all payments, including the mortgage payment, can be met. The underwriting process also includes a careful evaluation of the borrower’s credit history.
The underwriting process can take days or even weeks, according to FinWeb.com. Although most people think that lenders only send mortgage applications through underwriting, many banks also underwrite personal loans, business loans and home equity loans. Underwriting can help lenders determine the level of risk associated with each loan, but these certainly cannot be considered to be “fast” loans.
After evaluating the chances that the borrower will not make timely payments or may default on the loan, the lender can then assign a risk premium. In the example given in the previous section, the lender would be able to offer an interest rate of 8 percent plus the risk premium.
If the borrower has a credit score of 800, has been employed by the same company for 10 years and has a credit history that shows no late payments or high balances, the lender may assess a risk premium of 2 percent.
If the credit score is 700, the borrower has changed jobs within the last year, has two late payments on his credit history and owes a substantial amount on a credit card, the risk premium could rise to 8 percent or more. For a borrower with an even lower credit score and sketchier credit history, the risk premium will easily be in double digits, dramatically increasing the interest rate.
Lenders offering fast loans do not typically have a formal underwriting process. They may confirm employment, but that step may be as simple as requiring a check stub from the borrower. They may perform a credit check, but many lenders offering fast loans with bad credit either omit that step or do not use the borrower’s credit score as a basis for approval. Borrowers may have to supply a photo ID, a copy of a utility bill or a lease, but specific documentation varies by lender.
Other Factors Increasing Interest Rates on Fast Loans
The ease with which borrowers can secure fast loans online or at a physical location is a major reason for the higher interest rates on these types of loans. However, there are other factors that can influence the higher rates. For example, some lenders use their historical records on defaults to determine the risk premium; if 50 percent of the borrowers at one lender default on their loans, the lender will likely charge a higher interest rate than a lender with a default rate of 20 percent.
Fast loans are usually unsecured, meaning the borrower does not pledge an asset that the lender could seize if the borrower defaults. Whether they are bank loans or fast loans with bad credit, unsecured loans almost always carry a higher interest rate than secured loans. This is one reason that rates on mortgages and new vehicles can be so much lower than the rates on personal loans; if the borrower fails to repay the loan, the lender can claim the asset and sell it to recoup some or all of the amount loaned.
Lenders who make fast loans online sometimes have to deal with issues of fraud, including identity theft. Borrowers and lenders never meet face-to-face, so some lenders have incurred losses due to criminal activities. The greater risks can drive some lenders to increase their interest rates to help offset potential losses.
The clientele served by a lender making fast loans can also influence the interest rates charged. A lender offering fast loans with bad credit must charge more than a lender requiring a credit score of at least 600. Borrowers with consistent monthly incomes tend to pose less risk than borrowers who work seasonal jobs or whose income fluctuates widely from week to week.
Last but not least, lenders must consider any local or state laws pertaining to these loans. In areas where lenders cannot charge application fees, for example, they may increase interest rates. The same may be true if the law prohibits refinancing fast loans.
How to Learn More About Fast Loans
As you can see, there are a number of possible reasons for higher interest rates on fast loans. However, not every reason is a factor for every lender. Whether you are looking for fast loans with bad credit or excellent credit, you should take the time to compare interest rates and other fees before making a decision. To learn more about fast loans, you can visit the Personal Money Store to find educational articles about a variety of credit products that could help you solve your financial issues.