Borrowing Money: The Link Between Interest Rates and Risk

Have you ever applied for an online loan with a surprisingly low annual percentage rate (APR) only to discover that the actual loan you were offered carried a much higher rate? There are two possible reasons for this. First, advertised rates are not typical rates. Second, the actual rate offer you receive is linked to the amount of risk you pose.

Everything in lending is about risk. Lenders take a risk every time they hand borrowers money. In the most straightforward terms, they risk losing every penny. It is not likely, but the possibility always exists. The thing about risk is that it is assessed in different ways depending on the particular type of loan being analyzed.

Risk and Home Mortgages

Home mortgages are a good place to start because most of us are familiar with them. If you were to go to a bank in search of a mortgage, they would have to assess risk on several fronts. First is the value of the home itself. Is that home likely to retain its value over the life of the mortgage?

A second source of risk is you, the borrower. A bank needs to know how likely you are to default on your loan. How do they determine that? Through an underwriting process that looks into every aspect of your creditworthiness. The bank will look at your income, credit score and history, current debt load, and anything else it deems germane to its analysis.

Where you fall on the credit worthiness scale determines your interest rate. A higher position will mean a lower interest rate and vice versa. If you rank too low on the credit worthiness scale, you might be denied a mortgage altogether.

Risk and Hard Money Loans

Next, let’s look at hard money loans made by companies like Actium Partners out of Salt Lake City, UT. Actium Partners primarily writes hard money and bridge loans for real estate transactions. The thing about hard money is that it is an asset-based lending model. Lenders don’t look at creditworthiness. They do not look at income, credit scores, and debt ratios.

What matters to Actium Partners is the value of the collateral being offered as security. But this creates risk. Actium just assumes that a borrower will pay back what he owes. But that is risky. As a result, its interest rate tends to be higher than what you might find on a comparable conventional loan.

Risk With Other Types of Loans

Home mortgages and hard money loans present the highest levels of risk in secured lending. But there are plenty of other types of loans with their own risk profiles. Think of auto loans and home equity lines of credit. In both cases, lenders need to consider a borrower’s credit worthiness. But with a home equity loan, there is an added risk: being in the second or third lien position.

Don’t forget unsecured credit instruments, like credit cards and revolving lines of credit at department stores. Both types of loans are considered unsecured because there is no collateral creditors can look to in the case of default. Here the risk is enormous.

Unsecured credit is so risky that interest rates tend to be extremely high. For example, 19% on a credit card isn’t unusual – even for someone with stellar credit. Without collateral to act as security, credit card companies shoulder nearly all of the risk themselves.

Now you know how risk is linked to interest rates. Here is the long and short of it: the amount of risk you pose to lenders directly affects the amount of interest you pay.