As I stated previously, almost all lending rates start out the same, and then are adjusted for risk. This is true with “the big three” of loans that many people get – credit cards, auto loans, and mortgage loans. And they all have different risks to lenders (with credit cards being the riskiest, to homes being the least risky). Let’s look at all three:

Credit Cards – Easily the biggest lending risk out there. This is because they are usually given out unsecured by any collateral. And add to that the things people buy with them have almost no resale value (TV’s, Blu-ray Players, dinner at the Golden Goose, etc.) So the credit card issuer is taking on a ton of risk, which means rates are really high (18-25% typically).

Cars and other vehicles – These are squarely in the middle of the “risk” table. To begin, there is often a down payment required, so the borrower has something in the deal. In addition, in most cases, the vehicle has a fairly robust resale value. Yes, it’s not going to recoup things 100% for the lender (after all, the vehicle is worth less the minute you drive off the lot), but while the loan is active, the thought is the vehicle could be repossessed and sold. So while the lender isn’t happy when they have to repossess (and you are even less happy when the repo man shows up), at the minimum, they are going to get something back. So auto loan rates reflect this “lessened” risk.

Homes – Historically, real estate typically goes up in value. Ok, perhaps that bubble burst in the last recession, but that’s an anomaly – a home and property can almost always be resold. Add in a down payment, and you have a situation where the lender has a much smaller risk. This is why mortgage rates are the lowest of these three loan types.

The above doesn’t include a borrower’s credit score (which matters) and down payment size (which will also matter), but those tend to vary from loan to loan. But barring that, the risk assumed is what makes these three types of loans so different from each other in terms of rates. So that’s why you are paying 20%APR for that prime rib.

So the other day I get asked “Fletch, why are credit card rates so high, higher than things like automobiles and mortgages? Well, the answer is pretty basic (and makes for a good blog post). In fact, it can be boiled down to one simple word: Collateral.

In plain terms, interest rates are partially determined by how much risk is involved in a particular loan transaction. The less risk involved, the lower the interest rate (in general terms).

Now, risk is measured several ways: it’s measured by your credit score, and it’s measured by how easily the lending institution can recoup their money in the event of a default. In terms of credit cards, the second part is the biggest factor in determining interest rates. In short, it is MUCH easier to recoup money on real estate than it is on the DVD player Uncle VISA bought you. In fact, the minute you opened that DVD player and used it, it became generally worthless to the credit card company (ever try to sell a used DVD player?)

And what about last night’s dinner, where Uncle Visa again picked up the tab (nice guy he is, huh?) If you default, can the credit card company recoup that meal? Will they even want to?

That’s the reason credit card rates are so high – there is almost no recourse for the credit card company. If you default on a car loan, well, the car can be repossessed. Yes, it won’t have full value, but it has some value. And a home/property? Again, it holds value far more than a DVD player does.

You can use the above to gauge how much “collateral” will affect the rate – if the lending institution can easily recoup their money, it lowers their risk, and should (in most cases) offer a better rate than something they have no chance (or interest) in repossessing.