Over time, money loses value, where future cash flows will be discounted by certain amounts over present ones. This principle is the main driver of people borrowing money, because otherwise, they could just save up for the purchase or whatever they plan on using the money for, instead of borrowing it and paying interest on it.
Both borrowers and lenders discount these future payments, and this allows for markets to be made in borrowing and lending money. Borrowers want the money now, and are willing to pay a price for that, and lenders are willing to part with their money now, but require that the payments they receive back in yield a certain profit.
How much extra lenders will require in order to lend to certain people is what we call pricing of loans. These prices will be expressed in terms of the amount of interest that will be set for the loan, whether this be with a fixed interest rate or a floating one based upon a benchmark, where a spread is used to determine the rate based upon the underlying rate.
Whether one chooses a fixed or floating rate, the pricing of interest rates ultimately depends on the interest rate market in general. While there are certainly other factors involved such as a borrower’s credit worthiness and collateral, the interest rate market and interest rate forecasts provide a baseline from which these other calculations and determinations are based upon.
Many people look at loan pricing and assume that it’s all about risk assessment, where a bank lends out their deposits and charges based upon an expectation or reasonable profit plus whatever default risk they assume is present.
There’s more to it than this though, and the easiest way to envision the influence of the changing value of money is to look at how the buying power of money diminishes, in other words, the way that money loses value over the years.
If you borrow $10,000 today, and will pay it back in 5 years’ time, in 5 years this $10,000 will be worth less than it was back when you borrowed it. How much it loses depends on inflation, and in times of higher inflation you are going to need to pay more of an interest rate premium to make up for this, aside from all of the other considerations that need to be taken into account in pricing your loan.
The Interest Rate Market
Loans involve a stream of payments over the term of the loan though, so this affect is spread out over the life of it. Therefore, the entire principal isn’t subject to the rate of inflation over the term, but it is exposed to inflation nonetheless, albeit gradually. This effect is still a significant one, and is especially apparent when we look at longer term loans like mortgages, which can run as long as 30 years.
If you took out a mortgage that long ago, and your payments were $500 a month, that was a fair bit of money back in the 1980’s, but is worth considerably less today. As the mortgage got paid back, this payment became worth less and less with each passing year, where today it has lost a lot of value in terms of the buying power it provides.
This happens to some extent with all loans, and lenders have to take this into account when they price their loans. In order to do this, they look to the overall interest rate market to determine trends, as well as looking at the economic factors that drive it, things like monetary policy, inflation projections, and so on.
What is sought here is to determine general costs and valuations for lending money generally, from which a base will be built and projected, and from there more specific details related to the prospective borrower and the particular circumstances of the loan will be taken into account and adjustments will be made based upon this further information.
This is much like looking at a bank’s prime rate and the way it changes over time, and then taking this prime rate and applying it to borrowers, where they will require certain amounts of interest rate adjustment when loans are offered to them for various purposes.
So there are two main elements in pricing loans, the underlying interest rate market and the risk profile of the loan, where there will be a premium added to account for the level of risk present.
While lenders do compete with each other, making the market for borrowing more efficient, there will be a floor to this, as lenders do require to be compensated sufficiently for them to lend. Depending on the credit worthiness of borrowers, they may not qualify for bank loans and may have to seek to borrow from lenders who cater to higher risk borrowers. There is a market for borrowing to suit all risk profiles, provided that there is a reasonable expectation of repayment.
The interest rate market itself is a pretty broad one, as this involves all sorts of transfers, from depositors to lenders, from lenders to lenders, and from governments or central banks to lenders. Due to the structure of banks, where they lend out assets over time but need to manage the repayment of the loans they take from depositors over shorter periods of time generally, this requires borrowers to borrow as well, and this is why interbank rates matter as much as they do.
Depending on the climate, one may borrow at higher or lower rates, all other things being equal, and these rates can vary a lot. For the borrower, this really isn’t too complicated, especially if they choose a fixed rate loan, but if one chooses a floating rate, one must be at least somewhat aware of how the pricing of their loan may change over its term and how this may also impact their ability to keep up with the payments.
Pricing Based Upon Risk
Risk based pricing with loans is what determines what rate you will receive in any given interest rate climate. The base rate includes everything but risk, meaning how the income stream will be discounted, the influences of the interest rate market, the cost of borrowing to the lender, their profit expectations and desired return on investment, and so on, independent of lending risk.
It is the lending risk, the risk of default, that varies among borrowers, and the task is to determine the level of risk involved and price it into the loan. This is why the most creditworthy borrowers get the best rates generally, and the riskier that you are perceived to be by lenders, the higher the rate you will tend to pay.
Much of this is determined by collateral, as well as the type of collateral put up. If one is borrowing to buy real estate for instance, collateral that tends to increase in value over time, then as long as one is seen as minimally creditworthy, borrowers will generally receive the same rate, and those with excellent credit aren’t really treated differently than those with only modestly good credit.
With other secured loans such as car loans, where the assets put up depreciate over time, the security will both allow for better pricing on the loans and greater latitude with who will qualify for the best rates, with those with excellent, very good, and good credit perhaps all getting the best rate.
Unsecured loans are very risk sensitive on the other hand, and in these cases, all that lenders rely upon to price these loans is the creditworthiness of the borrower, so creditworthiness will matter a great deal here. There typically will be a number of different rates offered to borrowers, depending on their classification, including of course the classification of unworthy should one’s credit not be up to the standards used in assessing risk.
Secured loans do have a much higher repayment rate, because the borrower has more of a stake in doing so, lest they lose their home or their car or whatever is securing the loan. Putting up a down payment also can help getting approved, although if that is all that is securing the loan, lenders will still rely primarily upon one’s credit history and may require a down payment in cases where the loan would otherwise be too unattractive for them to take on.
In all cases though, actively managing one’s credit score and history is important, although much less so in the case of seeking a mortgage than an unsecured loan or line of credit. Many people sweat their credit score a lot when looking for a mortgage, much more so than is necessary, as this is the type of loan that one’s credit history matters the least, and as long as it is at least decent, it won’t really affect the rates one will get.
This is because mortgage rates tend not to be risk based, there is one rate basically, and you either qualify for an approval or a no. People do get declined for mortgages all the time though, and poor credit is a sure way to get declined or have to borrow from a subprime lender, so it’s not that it doesn’t matter.
With other types of loans though, your credit score will matter quite a bit, and when looking for an unsecured loan in particular, it will matter a great deal when it comes to the rate you will be offered. Few people have much of an idea how to best manage their credit, and lenders like banks or the credit bureaus themselves aren’t a lot of help, aside from just the basics like don’t apply for credit when you don’t need to and make your payments on time.
Credit scores measure one thing and one thing only, which is default risk. Payment history, making your payments on time and not being more than 30 days late ever one one of them, of course matters, and not doing so can cast your credit score in the low end for several years.
There’s a lot more to credit scores than just this though, and while the formulas are complex, the basis for credit scores are not so complicated, and it all pertains to your being in a better or worse position to be trusted for more borrowing.
How often you open new credit products, as well as the percentage of your available credit used, are the two main drivers of credit scoring, aside from defaults and late payments. The focus isn’t so much on what’s going on now, but what may happen later, if your balances escalate or you take on more debt down the road, more than you can perhaps handle.
There is a lot to be learned from just monitoring your credit score regularly, especially seeing how it changes as your situation changes, and doing so diligently can allow for borrowers to put themselves in better positions to borrow when needed and to qualify for better interest rates on their loans.
John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.