Understanding our Risk Profile When Looking to Borrow
When we borrow money, there are a number of things that lenders look at to determine what we may qualify to borrow, and these factors not only determine our approved borrowing capacity but also may determine what rates we may be able to borrow money at.
Lenders perform this analysis to determine their risk in lending us money. They will have a certain risk appetite, which is the maximum that they are willing to take on when lending. If we fall within the acceptable range, then they may further define this to determine what rate they require to justify their risk and have a reasonable expectation of profitability from the loan.
There is always a risk that a loan may not be paid back, no matter how stable and reliable one’s situation may become. Different types of lenders have different risk appetites, which range from banks which have the least appetite for risk to payday loan companies whose lending standards are limited to your proving that you are receiving income.
One’s credit score will define what we could define as variable risk, where we look at the history of one’s credit utilization and predict future patterns and risk of default.
Lenders really only care about one thing, which is whether we pay back the loan as agreed or not, and while it may be argued that credit histories go back too far and things can change a lot in 4 or 5 years, we also need a long enough history to be confident enough about these changes.
Our risk, all other things being equal, will therefore vary depending on our behavior, how well we handle what is otherwise deemed to be a sufficient capacity to repay, although this capacity calculation assigns a certain amount to discretionary spending and as we are prone to exceed this, our risk of default rises.
We need to make sure that we do have the means to repay the loan though, so this is where capacity comes in, the fixed side of the risk. Lenders will look at our financial obligations such as housing payments and payments on other loans and want that to be within a certain percentage of our income.
Like with credit scores, lenders can have different appetites for capacity, for instance a bank declining an application but a B lender accepting a higher ratio and compensating for this with their higher rates, which can reach 40% or more depending on the situation. When you take on higher default rates, this must be made up for by higher amounts of interest earned per loan.
Other Factors That Contribute to our Perceived Risk
Once the base risk is established for a loan by way of the borrower’s credit history and it is established that they have the means to repay it in a manner that we feel comfortable enough with, lenders may also look to further define this by looking at potential influencers such as the length and the quality of the relationship with the client, including what they perceive as their character.
In addition to one’s external credit history, lenders also maintain an internal credit history, and building a good history and relationship with a lender can reduce the borrower’s perceived risk overall and allow for better rates than would otherwise be provided.
Our investment in the loan also matters, and can matter a great deal depending on our involvement. There are two sides to this which can help our case, which is our willingness to commit to this and its positive reflection upon us, and our investing our own resources in the loan to reduce the impact of our ending up defaulting.
We may put up our own money for what is being purchased, called a down payment, and down payments always strengthen loan applications. Provided that we can comfortably afford making one, this also will reduce our interest payments over the term of the loan by reducing its principal.
We may either voluntarily make this down payment or it may be required in some cases, where it is needed to strengthen the application enough to get an approval.
We also may pledge collateral to secure the loan, resulting in what we call secured loans. Like with down payments, this may be voluntary or required, although with certain types of loans, involving larger amounts, they are most often required and a standard practice.
An example would be with a mortgage, which always requires us to secure the mortgage with the title of the home. Banks and other lenders don’t really own our homes that we have mortgages on, as is supposed by a lot of people, although if we default on the mortgage, the lender can exercise their right to have the title transferred to them.
This is the case with all secured lending and it is called a lien on the title of the ownership of something, whether that be a house, a vehicle, or other item of value. The security pledged is generally the value of the item purchased by the loan, but it may also involve pledging other items such as securities to obtain funds for something else.
Once we pay back the loan, the lien on the ownership of the property is removed. In some cases, such as with a mortgage or secured line of credit, both of which place liens on our home, we may be charged fees to remove the lien, called discharge fees. Real estate is more complicated than chattels though and costs more to discharge and this gets passed on to us.
Given the opportunity to secure a loan, we should always do so unless the intent is to not pay back the loan. Otherwise, we stand to benefit from not only getting an approval where we may not otherwise, we will enjoy lower interest rates due to the lower risk to the lender and this getting passed on to us in interest savings.
Understanding the Impact of Securing Our Debt
Aside from home purchases, which are always secured, there are other purchases that we have the option of choosing between a secured and unsecured loan, when we buy a car for instance. In spite of almost all car loans being secured loans, where the car is pledged as collateral, we may be able to get a loan to buy the car by way of what is called a demand loan, which is provided based upon our agreement to repay alone.
If we choose a demand loan when we could have obtained a secured loan, this will involve paying higher interest rates for it, where the downside of a secured loan is that if we don’t pay it back, we will forfeit the item and have it disposed of to settle our debt.
Should there be a surplus when the item is sold by the lender, we get to keep it, but if there is still a balance left owing, we still owe it. We also need to keep in mind that when items are sold to settle loans, they tend to be sold as quickly as possible and for amounts that are often well beneath normal market value.
If we buy a car with a demand loan and default on it, this doesn’t mean that we get to keep the car, as it may be subject to other actions that the lender may take against us, for instance by getting a settlement in court that results in the car being seized anyway.
All we are really doing when we pledge security is offering an alternative means to repay what we owe, with the primary means being making the requirement payments in a timely way. We should therefore not see providing security on a loan as undesirable in some way, and should choose to do so whenever possible.
The decision to choose to repay money borrowed by either a secured or unsecured loan extends well beyond just putting up what we buy as collateral, as we can use our existing home equity to either make purchases, or more often, to consolidate unsecured debt to achieve more favorable terms.
We often miss these opportunities due to a lack of proper understanding of the benefits of this, and the public in general tends not to appreciate how much secured borrowing can help us. We usually get guided toward this by the lenders themselves, but ideally, we should be the ones taking the initiative here. We can only do so when we already understand well enough how we can benefit and by how much.
Secured loans on our property cost money to set up though, and while the lender is happy enough to provide us their end of things without charge, as is the case with loans generally, making changes to the title of our property involves legal costs which we must pay for. There is therefore a threshold that we need to reach where the benefits outweigh these costs, but this is often easily achieved.
The Benefits of Secured over Unsecured Loans
There are two main effects of moving money owed on unsecured loans to secured loans, which are reducing the payments we need to make by amortizing the added amounts over a longer period, and the savings involved with the interest rate differential.
We will be paying a lower, and often much lower interest rate on secured loans, and this is the main reason why we should prefer to repay the debt at a lower rate. All other things being equal, it is preferable to pay the least amount of interest that we can, and to figure out the rest all we need to do is add the costs of the loan to the interest costs and see which option is cheaper.
Credit card debt is particularly nice to refinance with a secured loan, given their typically high rates. If we are saving 15% or more on the rate, the amount involved does not to be very high to produce overall savings for us. Even differences of a few percent can matter if the amount refinanced is high enough.
Making changes to the title of our home should not be done any more often than needed, and anytime we change the amount of our mortgage, this will require legal costs. Mortgages which reserve a fixed lien on our property or a secured line of credit, which does the same thing, can save us future legal costs while still providing all of the benefits of a refinance.
This allows us to refinance our debt upon demand, subject to the limitations of our available credit balances. Instead of loading up our credit cards and then later paying for a standard mortgage refinance, we can instead pay off the credit cards on time, without accruing any of their high interest, and maintain funds we need to borrow on our secured products.
This not only avoids excessive refinance costs, it also has us paying the better rate right from the outset instead of periodically refinancing it and leaving it subject to the higher rates for a period of time as we wait for the refinance to become viable.
Money owed on secured products with a revolving component also has the benefit of greater transparency, and this will generally allow it to be paid back faster. Imagine that you owe $100,000 on your mortgage with 20 years left to pay it off, and you end up adding $10,000 of unsecured debt to bring the balance to $111,000 including costs. The chances of your paying this off are less than if this amount was kept separate.
If this balance will amortize over 20 years, it will go down slowly as the rest of the principal of the mortgage will, and by observing this separately, we can discover and manage this should we wish to pay it sooner. Few people actually make the additional mortgage payments that paying off added debt sooner would require, and the tendency is actually to let the debt get paid down over the life of the mortgage.
When this happens, as it so often does, this involves paying a lower rate than the unsecured loan had, but paying it off over a longer and even much longer time. If you have a 4-year car loan that you can save a couple of percent on, and you pay it off over 20 years instead, it will cost you a lot more in the end, so this effect must be properly accounted for.
Revolving products or revolving portions of a secured loan both allow us to see this extra money that we added and monitor it much better, it also allows us to pay it down more aggressively as it provides a means to take our payments back if we need. The money that we may want to save for contingencies can therefore be put on the loan without any fear of undesirable consequences.
We also can end up reducing our capacity as we add more debt to our home, and this is a particular risk if we have not learned to reign in our spending. Refinancing is a great idea until you get to the point where you have added so much to the house that this constrains your ability to service your other debts.
We might think that this is a good thing, but the problem arises when sound judgement is not provoked by our capacity reducing and we keep borrowing anyway. While this can easily lead to insolvency, we at least don’t have to include our home in the bankruptcy, although bankruptcy otherwise is not a pleasant situation to be in.
Secured loans are certainly preferable over unsecured loans in all cases, but we still need to be careful when using them and take all factors into consideration, including coming up with a good exit plan, the part that so many people do not consider well enough.
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.