3 ms·

I think you need to factor in risk. This is a simplistic example but demonstrates the influence of risk. Who would you rather lend a mortgage to? - Group A, c

by merek 3y ago

I think you need to factor in risk. This is a simplistic example but demonstrates the influence of risk. Who would you rather lend a mortgage to? - Group A, consisting of people who prudently pay debts early - Group B, consisting of people who pay debts on their due date, and sometimes after Let's say you lend $100B to each group A and group B. Historical data might show that in aggregate, group A has a default rate of 1% and group B 5% (there's 5% chance that a person from group B defaults on the loan). Because of defaults (risk), you expect to lose $1B of principal on group A and $5B principal on group B. To break even, you need to charge group A interest that would at least offset their $1B loss, and charge group B interest to offset their $5B loss, hence group B's higher interest rate. One group is not automatically more profitable than the other. Group B might incur more costs such as late fees, but this only works against their ability to make future payments.

TexanFeller 3y ago
Risk is for sure a large component of profitability, I didn't mean to imply otherwise. But risk is not the only factor and credit scores often seem to track the total profitability curve better than the risk curve.
orbisvicis 3y ago
Totally outside my wheelhouse, but I'd imagine that interest on debt could eventually make group B more profitable if the default rate isn't too high. Or perhaps have group A partially cover the interest of group B because they're lower risk and likely have higher income. I imagine that late fees increase the cost of repayments while debt interest increases the number of payments thus not hindering the ability to make future payments.
kristianbrigman 3y ago
It’s more than that - banks used to have prepayment penalties. People with high credit scores are (probably?) also more likely to move, which means the bank may only get a couple years of interest until you pay it back (when you sell to buy a new house with a new mortgage), vs. people who stay in their house for many years. These things mean that someone with a lower score may be a better investment for the bank. If it sounds ridiculous… imagine that every month, all the mutual funds you are invested in shut down and gave you your money back (with interest), and you had to choose from a whole new set. Some of you probably do this anyways, but most people prefer to make the choice once and then just let it grow.

by merek 3y ago

TexanFeller 3y ago

Risk is for sure a large component of profitability, I didn't mean to imply otherwise. But risk is not the only factor and credit scores often seem to track the total profitability curve better than the risk curve.

orbisvicis 3y ago

Totally outside my wheelhouse, but I'd imagine that interest on debt could eventually make group B more profitable if the default rate isn't too high. Or perhaps have group A partially cover the interest of group B because they're lower risk and likely have higher income. I imagine that late fees increase the cost of repayments while debt interest increases the number of payments thus not hindering the ability to make future payments.

kristianbrigman 3y ago

It’s more than that - banks used to have prepayment penalties. People with high credit scores are (probably?) also more likely to move, which means the bank may only get a couple years of interest until you pay it back (when you sell to buy a new house with a new mortgage), vs. people who stay in their house for many years. These things mean that someone with a lower score may be a better investment for the bank. If it sounds ridiculous… imagine that every month, all the mutual funds you are invested in shut down and gave you your money back (with interest), and you had to choose from a whole new set. Some of you probably do this anyways, but most people prefer to make the choice once and then just let it grow.