Consumers who need financial help in emergency situations do not have the cash they need to cover expenses. To help out, lenders offer loans that allow people to borrow money, and then pay it back over time. Interest is added to the principal to compensate the lender for its part in the loan. When you consider the risk the lender is taking to make the consumer’s life easier with an emergency loan, it makes sense to allow the lender to make a few dollars for its trouble.
What exactly is Interest?
To compensate itself for the risk and costs associated with loaning money, the lender will add interest to the principal being borrowed. Think of interest as the motivation the lender needs to get you the money you want.
Breaking Interest Down
Interest is broken down into four parts; principal costs, administrative costs, risk and profit. These are all percentages that, when put together, create the overall interest rate you pay on a loan.
- Principal costs – These are the marketing and administrative costs the lender incurs to acquire the loan principal. This could be through investments, borrowing from other lenders or in-house customer accounts.
- Administrative costs – These are the costs required to put together and monitor your loan.
- Risk – When the lender gives you money, it is taking a risk that you won’t pay it back. This percentage helps cover any costs associated with potential default.
- Profit – The lender could be using the principal it is giving you on other investments that could be more lucrative. This profit percentage helps compensate the lender for any revenue it could be missing out on by giving you the loan.
These are relatively small percentages that are brought together to create an interest rate. For example, the principal costs may be 4%, administrative costs could be 1%, the risk is 2% and the profit is 2% for a total interest rate of 9% on the loan.
When a lender pulls money out of its piggy bank and gives it to you, there is a chance that you will default on the loan. The problem for the lender is that a defaulted loan does not put any money back in the lender’s piggy bank. That is why part of the interest rate is used to cover your risk.
The risk applied to your loan is determined by:
- Your personal credit score and history with other loans.
- The length of the loan.
- Whether the loan is secured or unsecured.
Length of the Loan
The longer you have the lender’s money, the greater the risk that you will default. The trade-off for the lender is the longer you have the loan, the more money the lender can make in interest. A lender charges interest, in part, to make sure that there is revenue available if you should default on a loan. That is why a borrower will pay more interest than principal in the first few years of a mortgage. The bank is trying to lessen the financial damage if you should default.
Better Uses for the Money
Another reason that lenders charge interest is their belief that they have better things to do with their money than give it to you. It sounds a little smug, but it is true. If the lender is charging you 9% interest when it could be using that money to get a return of 12% on another investment, then they are losing money. The profit figured into a loan is designed to offset this kind of loss. The lender feels more comfortable about giving you the money if it knows that it can still make a good profit on it.
The interest rate of your loan is affected by whether or not the loan is secured. A secured loan is backed up by some sort of property that the lender can sell if the borrower defaults.
Car loans and mortgages are good examples of secured loans, while a credit card is an example of an unsecured debt. This is why credit card interest rates tend to be significantly higher than mortgages or car loans.
Now comes the part that consumers and borrowers love to hear when it comes to interest rates. There is a lot of competition out there for your business, and that competition helps to keep interest rates low.
One of the elements of an interest rate that lenders often refuse to lower is the profit margin. In most cases, the profit margin is a standard number that is applied to all loans. But the other three parts of an interest rate can be manipulated to make the overall interest rate more competitive.
The other elements of an interest rate are adjusted either based on your personal credit or in response to competitive pressure. For example, lenders are always looking for ways to lower their administrative costs so that they can keep loan interest rates down.
Interest rates can be a mystery to the average borrower, but they are an essential part of the entire borrowing process. The lender takes on a significant amount of risk and potential loss when it approves any kind of consumer financing. The interest rate helps to offset that risk and makes it easier for the lender to offer you financial help.