Most of us will hold debt at some point in our lives. Some forms of debt, such as student loans or mortgages, have relatively low interest rates and are often classified as “good debt.” Other loans, such as credit cards, have very high interest rates and would be considered “bad debt.”
But what determines the interest rate of a loan? Specifically, why do student loans charge low interest rates and credit cards always charge high interest rates?
Factors That Influence Loan Interest Rates
In general, the profit off of each type of loan should be roughly the same when adjusted for the riskiness of that loan — otherwise, lenders would flock to the more profitable loans and avoid offering the less profitable loans. Investors are hungry for as much return as possible, and competition and market forces will drive the interest rates of loans up and down.
Risk-free interest rate
The minimum interest rate on all loans, unless the lender is able to earn money through other means (e.g. a higher purchase price on a car sold with a 0% loan), is the risk-free interest rate. It is the interest rate on loans assumed to have zero chance of default (i.e. United States Treasury bonds). U.S. Treasury bonds have a AAA rating, and in times of market distress, investors from around the world flock to these bonds for safety.
Risk of Default
Loans that have a higher risk of default will offer a higher interest rate. Lenders do not expect to make the full interest rate they are charging, because they know some percentage of their borrowers will not pay back their loan. Remember that yield does not equal return.
It is easier for some borrowers to walk away from some loans than others. For example, defaulting on a mortgage would mean losing the house you live in. Therefore, borrowers are less likely to fall behind on their mortgage than on other loans. Student loans are generally not discharged in bankruptcy, so the default rates for these loans are relatively low.
Recovery rate / collateral
In the event of a default, the lender will work aggressively to recover as much of their money as possible. When a loan has collateral, such as a mortgage or auto loan, the ability to recover the money is straightforward — you just liquidate the collateral for cash. For loans that are unsecured (i.e. have no collateral associated with the loan), it becomes harder to get back your money. Recovery rates tend to be lower for unsecured loans.
Example Loans – Ranked by Interest Rate (Low to High)
Treasury bonds have the lowest interest rates. There is assumed to be no risk of default, so you will always get your money back.
Car loans have a fairly high risk of default, but there is also a very high recovery rate, since lenders can repossess the car and sell it. The interest rate on car loans is highly dependent on the borrower’s credit score.
Sometimes a car loan is used as an incentive to buy the car. Often times, you could buy a car for less if you pay cash upfront, or get an interest-free loan on a higher list price for the car. This is why many auto loans have lower interest rates than you might expect based on its risk of default and recovery rate.
It is also why if you are willing to pay cash for a car, you can often negotiate a lower price for the car than if you are obtaining financing. By paying cash, the dealer has no risk of default, and most car buyers these days expect a low interest rate on their car loan, so they need to charge more for the car to make up this difference.
Mortgages have a relatively low-risk of default compared to other loans. Because the penalty for defaulting on your mortgage is losing your home, a mortgage will be one of the last loans a borrower will miss payments on. Of course, the risk of default (and therefore the mortgage’s interest rate) depends on the homeowner’s credit score.
There is a moderate to high recovery rate on mortgages, since the mortgage company can liquidate the house at a foreclosure auction. However, the foreclosed home will frequently be sold at a discount to its market rate.
Like car loans, mortgage companies will often offer lower than market rate interest rates in exchange for higher closing costs.
Student loans have a low risk of default because they typically do not discharge when the borrower files for bankruptcy. However, student loans will also have a low recovery rate, because there is no collateral associated with the loan.
Personal Loans (e.g. Peer-to-Peer Loans)
Personal loans, such as peer-to-peer loans, have a moderate risk of default that is dependent on the credit score of the borrower. Like student loans, personal loans have low recovery rates because they are unsecured.
Credit cards have the highest risk of default. These lines of credit generally have the lowest standards for credit, and they do not discriminate their interest rates by credit score. They offer the same interest rate whether you have a perfect credit score or a terrible credit score.
In fact, the interest rate is irrelevant to consumers with excellent credit scores because they will not fall behind on their credit card payments. Therefore, the only people who will be paying interest on their credit cards are precisely the borrowers who are at the highest risk of default. Because credit cards have low recovery rates in bankruptcy, they charge the highest interest rates.
Here’s a summary table of the various types of loans, along with their risks of default and recovery rates. You see that their interest rates are ordered relatively neatly based on these two factors. The use of below-market interest rate loans to induce consumers to purchase a car or house can cause the interest rates on car loans and mortgages to deviate from these rules of thumb.
|Loan||Default Rate||Recovery Rate||Interest Rate (approx)|
|Student Loans||very low||low||3-4%|
What do you think? What interest rate(s) do you pay for your loans? Are there any other factors influence the interest rates of loans?
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