Risk-Based Lending
Lenders often use risk-based lending when making lending decisions. Risk-based lending is a policy that helps institutions determine the borrower's interest rate. If a borrower is seen as a higher risk, then the bank will charge a higher interest rate on the loan. Of course, if the borrower is a low-risk borrower, then she can enjoy one of the best interest rates available. Often, lenders assign a letter grade to each borrower. As in school, an A is best, and D is often the worst.
How do you get the best grade? By having a good credit score, of course. Those with higher credit scores are the A borrowers, and those with lower credit scores are the D borrowers. Keep in mind, as your credit improves, your grade will also improve.
About the System
Risk-based lending gives institutions the ability to serve a wider population. In the past, lenders might have avoided customers with any blemishes in their credit history, and they might only have had one interest rate for each type of loan. If an applicant with bad credit tried to get a loan, the lender would probably respond, “Sorry, we can't offer you a loan.” The result was that these customers had to resort to finding loans in other places; typically they fell victim to predatory-lending practices. Finance companies, title loan programs, and rent-to-own stores were some of the only alternatives available to this population.
Nowadays, these folks can get a loan at a more reputable institution. Of course, the institution is entitled to be compensated for taking more risk with a borrower who has bad credit. How do they get compensated for this? They earn a higher interest rate on the money they're lending.
In addition to helping people who don't have good credit, risk-based lending helps people who do have good credit. Borrowers with a clean history enjoy low rates. They don't have to pay more to cover the losses on bad borrowers. The system gives borrowers the rate they deserve.
These programs are especially helpful for people who need to build credit, and for people who need to rebuild credit — they either have no credit history, or they have a bad credit history. For them, it is really difficult to get a loan. Risk-based lending may be the only option for them to find financing.
More Than the Score
Ultimately, getting a loan is about more than just your credit score. Lenders who use risk-based lending place a lot of weight on your score. However, they look at other factors, too. For example, they want to make sure that your income is sufficient to cover any debt payments that you're about to take on. Likewise, they will consider whether or not the debt is secured (such as an auto that can be repossessed, or a home that can be foreclosed on). Finally, they want to make sure that you can put some money down. If you don't make any down payment, or if the loan-to-value ratio is too high, they will be more reluctant to make a loan
If you want to calculate payments and fiddle with the numbers, you can use a spreadsheet program like Microsoft Excel. By using the PMT function, you can see how an installment-loan payment will change as you change the ingredients. Try increasing the interest rate to see how a hypothetical loan would change.
How Payments Are Calculated
Do you know how your monthly payment is calculated? There are only a few ingredients. To solve for monthly payment, you need to know the interest rate, the time period, and the loan amount. You can mix and match these ingredients to change how much the monthly payment will be. For example, if you increase the amount of the loan, it's pretty obvious that, all other things being equal, the monthly payment will go up, too. Likewise, if you stretch out the number of months over which you'll make payments on the loan, the monthly payment should decrease.
Do you know what happens if the interest rate goes up? That's right, the monthly payment increases. What do you get for this higher monthly payment? Not much. The lender earns extra income to compensate them for taking a risk on you. However, you don't get anything extra. You're buying the exact same auto, home, or other product, you just have to pay extra for it.
