Defaults are when borrowers, at some point in the loan’s life, cease making their payments. For this post, the reasons why are immaterial – at the end of the day, all that matters is the lender is out not only a (sometimes large) portion of the money they lent, but they are also out of the expected revenue from the interest. Since most businesses use some form of projected/expected income to operate, this is doubly bad for a lender. And no, “writing it off” does not make a lender whole by any stretch.

But it isn’t just the money/revenue lost. Most of the time, there was some form of collateral involved with the loan, which now must be repossessed. This costs money, as someone has to be paid to collect it. One other issue here: Since the borrower is generally in some kind of financial straits, this is typically not a pleasant experience. 

In addition, in most cases, the collateral does not make the lender whole. They still need to sell the item, and they almost never recoup even close to what is owed.

There’s another aspect to defaults that often goes unnoticed by those outside the lending industry: how defaults make a lender look to regulators. Too many defaults will often bring increased regulation on the lender, and increase their capital requirements. Nevermind that perhaps the defaults were an anomaly and not really the lender’s fault. That won’t matter to the regulators; to them, the lender is writing too many risky loans and will be treated as such.

Lenders use an immense amount of data to qualify borrowers, and, much like the insurance industry, attempt to predict default rates based on various lending criteria and borrower/loan profiles. Now, of course, lenders can’t predict which specific borrowers may default, but they do have to honor what the data tells them about the aggregate. These predicted default rates are factored into the lender’s overhead and become part of the rate equation.

Despite the lender’s best efforts and the borrower’s best intentions, defaults in the lending industry are inevitable and must be accounted for.

Risk is one of the largest factors affecting the rates you pay. In fact, nearly all lending rates begin at whatever the Federal Funds Rate is, and are then adjusted upwards based on risk and lender overhead.

But risk is the big one, and it’s also quite variable, with almost all borrower risk profiles being unique, and quite multifaceted.  Of course, on the surface, you would think the borrower’s credit score essentially constitutes the lender’s risk. But it goes a lot further than that.

Indeed, I’m looking at my list of topics for this series:

1.  Common misconceptions about rates. (already posted)
2. The relationship between risk and the rate. (we are here)
3. How loan type and intended use affects rates.
4. Collateral and rates.
5. Internal cost of funds and rates (aka, “how much does money cost?”).
6. Defaults and rates.
7. Credit scores and other risk profiles affecting rates.
8. Benchmark rates and market conditions.

And I can see that numbers 3,4,6,7 are all directly related to risk. #8 also has a little risk in there. #5 doesn’t (and I’ll likely be including lender overhead in that one too).

So yes, risk is a big factor in rates. The more risk (taking into account all of these factors), the higher the rate. That’s the quick answer.

Now someone may ask “well, why is that? Why does the rate go up with more risk? Why does more risk to the lender cost borrowers more?”

Well, riskier loans have a higher chance to default, right? And in the aggregate, this must be taken into account. A lender cannot be profitable otherwise. 

Without getting too deep into the math, lenders use an actuarial approach similar to insurance companies. Just like insurers predict fire claims in certain demographics to set rates, lenders analyze numbers to predict loan defaults based on risk profiles. The thing is, the models cannot predict individual outcomes, so borrowers are categorized by credit score, collateral, loan type, etc.

Now I must be emphatic – loans going bad is a serious topic, as the consequences are devastatingly costly to a lender. Not only do they not get paid back the money they lent, but recouping any funds is difficult and drawn out.

For example, first think about the lender repossessing the item and selling it. All well and good, but this costs money – someone must physically retrieve the item (not always a pleasant transaction), inspect it, repair it, clean it, list it, and sell it. Nobody does these things for free. Plus, the item will certainly have significant depreciation. So repossession falls into the “better than nothing but certainly not optimal” bucket. 

In addition, defaults do not just disappear from a lender’s books – the money owed must be made back from somewhere. Can a lender “write off” some losses? Yea, sort of. But it’s a) complicated and time-consuming, and b) only a fraction of what was truly lost. 

Listen, defaults are always very unprofitable. And the money needs to be made up from other borrowers in the form of rates, which is exactly what we are talking about here. When I talk about risk, I am really talking about expected defaults, and that makes rates go up.

In the end, the rate on any given loan needs to be profitable enough to offset the expected loss for whatever the total risk profile is. Plus, lenders must also account that riskier loans require more regulatory rules (i.e., cash on hand, which we’ll discuss in internal costs). And that costs money as well. 

Like I said, the actual nuts and bolts of the “why” boil down to a complex set of math formulas that take all kinds of factors into account. But for purposes of discussion in this series, just understand that increased risk = increased rate.