John and Mary are individual buyers looking to purchase their first homes. They buy similar homes in the same neighborhood, utilizing mortgages from the same lender. John pays a higher interest rate than Mary. Do you know why that is? Do you know why consumers do not always get the same interest rates on all sorts of loans?
The answer is pretty complicated if you get into the details. But you can keep it simple by understanding a single principle: risk management. That is the name of the game for lenders willing to fork out hundreds of thousands of dollars to help consumers buy homes.
Lending Is Risky Business
The fact of the matter is that lending is risky business across the board. Whether it is mortgages, car loans, or hard money loans for real estate investment, lenders always face the risk of customer default. Risk is especially high in the mortgage industry because lenders are limited in how they can respond to default.
Interest rates are a tool that lenders can use to mitigate their risks. Think of interest as a fee banks charge for their service. The more they stand to lose on that service, the higher their fees will be. It is standard business practice.
Varying Levels of Risk
This brings us to the question of why two people applying for similar loans at the same bank can wind up with different interest rates. An explanation is found in the fact that people represent varying levels of risk. Let us refer back to our fictional home buyers, John and Mary.
John has a history of late payments. He can only produce the minimum 20% down payment, and his income-to-debt ratio is right at the very edge of what he finds comfortable. By the looks of it, he is just one disaster away from not being able to make monthly mortgage payments. Giving him a mortgage is pretty risky.
On the other hand, Mary’s credit history is pretty good. She can only muster a 25% down payment, but she has very little debt compared to her income. She gets a better interest rate because lending to her is not as risky.
Lending Beyond Mortgages
Managing risk through interest rates isn’t limited to mortgages. It actually applies to all sorts of credit. Take hard money lending. Hard money is generally reserved for commercial purposes, according to Salt Lake City-based Actium Partners. Actium says that hard money lenders assess higher interest rates because the projects they fund are considerably more risky.
Risk is a factor in auto loans, too. Banks look at the same factors that mortgage lenders consider; they assess risk by examining credit histories and scores. They also need to assess how much they could get for a repossessed car should it come to that.
Risk even plays into credit card financing. Credit cards are considered unsecured credit instruments, and credit card companies start out with a base rate that applies to everyone. But miss just one payment and the risk factor goes up – right along with your interest rate.
Some Rates Are Negotiable
If there is any good news here, it is that some interest rates are negotiable. Lenders do not advertise this for obvious reasons. But there are instances in which a lender would rather offer a lower interest rate than lose the deal. Credit card companies immediately come to mind.
At the end of the day, interest rates are heavily dependent on risk. Consumers are offered different interest rates because the amount of risk they present varies. The greater the risk, the higher the rate. That’s the way the game works.
