Loans for People with Bad Credit — Are the High Interest Rates Justified?

One way that lenders can reduce their risks is to charge higher interest rates for loans to people with bad credit, but is this approach justified?Lenders have long known that there is a correlation between how borrowers have handled credit in the past and how they will handle it in the future. If the borrower’s credit history is sketchy, the lender will want to mitigate the risk that the payments will be late or that the borrower will default.

Why Lenders Believe that High Interest Rates for People with Bad Credit Are Justified

Consumers today are bombarded with advertisements for credit products offering ridiculously low interest rates. New car dealers claim that customers can buy a car and pay no interest for the life of the loan. Mortgage companies advertise interest rates as low as 2.5 percent. Banks market credit cards with attractive interest rates as well.

• However, if you read the fine print, only borrowers with the best credit scores will qualify for these low interest rates. Whether they buy a home or a car, receive a bank-issued credit card, request a payday loan or accept a store’s financing option, people with bad credit will pay a significantly higher interest rate.

The lender’s justification process goes something like this.

• Borrowers with bad credit have shown that they cannot be trusted to make every payment on time. Lenders do not care whether the missed payments were the result of a lost job, traumatic illness in the family or simply a lackadaisical attitude about meeting obligations. They only know that previous lenders did not receive their money in a timely manner or failed to recoup their full investment.
• Lenders can expect to incur additional overhead expenses to service bad-credit accounts. There will be late notices or payment reminders that must be mailed, staff members will need to make phone calls and additional bookkeeping chores will need to be performed.
• If the loan is for a sufficiently large amount or is collateralized, the lender may incur legal fees to file a lawsuit or take possession of the property offered as collateral.
• If the loan is for a relatively small amount, such as with payday loans, the lender will likely attempt to collect for a certain period. If efforts fail, the lender will probably sell the loan to a third-party collection agency for a fraction of the loan amount.
• The easiest method to reduce the lender’s potential losses is to charge a higher interest rate that will allow him to recoup as much as possible as quickly as possible. The higher interest rate also helps offset the losses that the lender has absorbed from similar loans that have gone into default.

What Are Some Examples of High Interest Rates?

Loans for people with bad credit are relatively new. Several decades ago, if someone had bad credit, few banks were willing to issue them a credit card or approve a mortgage. Lenders have become more flexible over the past 25 years, and they have also become more innovative by offering products such as secured credit cards, personal installment loans and payday loans.

However, all of these products will carry a much higher interest rate that a similar product offered to a borrower with excellent credit.

• A few years ago, First Premiere Bank introduced a credit card for people with credit so bad that they could not get approved elsewhere. The card carried an interest rate of almost 80 percent, but surprisingly, thousands of people took the bank up on its offer. According to Consumerist, the company has since reduced the rate to 59.99 percent. The company stated that new regulations made it necessary to spread their risks among all customers by charging higher interest rates.
• Recently, lenders have become more agreeable to approving mortgage loans for people with bad credit, but the interest rates, monthly payments and total interest paid will increase as the borrower’s credit score declines. The calculator provided by MyFICO.com illustrates the concept. Based on a 30-year loan of $100,000, a person with a FICO score of at least 760 could receive an interest rate of 3.231 percent with monthly payments of $434, and over the life of the loan, he will pay $56,299 in interest. A borrower with a credit score in the 620 to 639 range would likely receive an interest rate of 4.82 percent, monthly payments would be $526 and the total interest paid would be $89,315.
Unsecured payday loans for people with bad credit often have annualized interest rates of 365% percent or more, but people with excellent credit frequently pay as little as 10 percent.

Are the High Rates Truly Justified?

To answer that question, it might be helpful to explore what researchers for the Federal Deposit Insurance Corporation found when they conducted a study on whether the costs involved with payday loans were justified. In brief, the researchers reported that “fixed operating costs and loan loss rates do justify” a major part of the annualized percentage rates charged by payday lenders. Similar evidence can be found to justify the higher interest rates charged for other types of loans for people with bad credit.

Explore Loans for People with Bad Credit in More Detail

Even if your credit history is blemished, you still have a number of options for obtaining the money that you need. You can find more information about the different types of loans available at the Personal Money Store.

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