Understand Why Cost of Borrowing is Higher than Returns for Savers
It is often asked why interest rates are always higher for borrowers than for savers. This article explains some of the factors used to set interest rates.
In simplistic terms a deposit taking and lending body such as a bank, building society or savings and loan company takes in money from savers and pays them interest for the use of that money. The bank then lends that money to a borrower and charges them interest on the loan. The lending company also needs money to administer the deposits and the loan. They also need to make a profit.
So the profit and administration costs come out of the gap between the interest charged to borrowers and that paid out to savers.
Need to Set Aside Funds to Cover Default on Loans
In the real world some borrowers will not meet their commitments and repay the loan and interest. The lending bank needs to build that into their administrative costs so that they can meet their commitment to their depositors, the savers. That means that in difficult times, such as recessions, when there tend to be more defaults on loans those administrative costs will increase.
Hence in uncertain financial times the interest rate gap between loans and savings will widen to compensate for the increased cost of defaults. This has been a major issue for banks during the recession associated with Credit Crunch and earlier recessions.
Interest Rates and Borrowers’ Credit Rating
Banks, usually, make efforts to place that additional cost on those borrowers most at risk of failing to meet their commitments. So customers who have consistently proved that they repay loans properly will tend to be offered lower interest rates on their loans.
Conversely those borrowers with a poor or patchy credit track record may not be offered a loan or credit card. If they are it will be at a higher rate to compensate the loan company for the extra risk the lender is taking that the debt will not repaid in full. Not all such borrowers will fail so the interest has to increase by an amount that reflects the proportion that will default.
Indeed at the time of writing a mainstream credit card interest rate was around 17% but for those with poor credit rating 35% is more typical. Some cards for particularly good borrowers are under 9%.
Same Rules Apply for Government and Company Borrowing
This approach is also true for companies and governments and the effect of risk on interest rates can be seen in the bond markets. Bonds have fixed interest based on their initial value but as they are traded the actual yield goes up and down. When a company or government is perceived as at greater risk of defaulting on its debt, its bonds, the price falls and the real yield (interest rate) increases as investors (lenders) expect a premium for the increased risk. The opposite is true when the risk falls, the price goes up and the yield therefore goes down.
Indeed, this is why Greece, Ireland and Portugal had to be bailed out by the International Monetary Fund, European Central Bank and the European Financial Stability Facility. They could no longer afford to pay the interest rates they were being charged on their bonds. For Greece rates reached over 24% which means investors see a 50% risk of Greece defaulting on its borrowing.
Risk Assessment and Credit Scoring
To help them assess the risk of lending to an individual banks will use their own knowledge and will use credit referencing agencies such as Experian, Equifax or Callcredit. They hold a wide range of details and use sophisticated algorithms to provide lenders with credit scores for potential borrowers. Lenders may use more than one agency to decide whether they will offer a loan.
Individuals can get a copy of the information held by such credit reference agencies so that they can correct errors or at least understand why they are being refused credit. Some agencies offer a free credit report and monitoring service to keep individuals informed of changes to their credit status so that they can spot possible identity fraud.
So the basic reason for the gap between interest rates paid to savers and borrowers is simple. The size of that gap is variable and depends on a wide range of factors that go beyond the scope of this article.
First appeared on Suite101