Credit Risk and Why Bad Credit Costs You

It's pretty much common knowledge that having a bad credit score is expensive. With a poor credit score you can expect to pay higher interest rates on mortgages, credit cards and other loans that over time can really add up. On a 30 year mortgage on an average sized home, a high interest rate can end up costing you over $100,000 by the time you are finished off paying the loan.

But this does not really explain why bad credit costs you money, only how it does it. A higher interest rate is not simply a penalty lenders assign to people with bad credit. And while stating that the higher interest rate protects lenders in case you default on a loan is true, that is still only part of the story. After all, if you end up declaring bankruptcy, it doesn't matter how much the lender charges in interest since you won't be making payments anyway.

With regard to loans, the real reason bad credit costs you money is because you end up paying other people's loans off too.

Credit Scoring and Predictive Modeling

The simple truth is that most people with a bad credit score are not a credit risk. Odds are if your credit score is below average, you are just as likely to pay your bills as someone with a 777 credit score.

The reason for this is that credit scoring is a predicative tool that works well at the aggregate level, but not at the individual level. What this means is that if you take 1,000 people with a 600 credit score, you can make a fairly accurate predication of how many of those people will default on a loan. But if you look at each of those 1,000 people individually, it is very difficult to tell which people will default and which will pay off the entire loan amount.

How Credit Scores Lead to Higher Interest Rates

Since lenders can't tell whether or not you as an individual are going to pay back a loan by looking at your credit score, they will group you with other people who have a similar credit profile. They can then use the predictive capabilities of credit scoring to guess at how many people in the group will default and how much they will have to charge everyone else to make up this loss.

Let's go through an example of how this works. This will be a very simplified walk-through that doesn't take into account partial payments, administrative costs, court fees, collateral, etc.

Imagine that a group of 100 consumers apply for a $1,000 loan. Each member of this group has a good credit score. The lender knows that based on this credit score, the odds are that 5% of people will default on the loan. In addition, in order to make the desired profit, the lender needs to see a 10% return on their investment. Taking all of this into account, we can find the amount of interest each good credit borrower will be required to pay.
Total loan amount
100 loans x $1,000 per loan = $100,000
Lender profit
$100,000 total loan amount x 10% profit = $10,000
Total amount repaid to lender
$10,000 profit + $100,000 total loan amount = $110,000
Number of paying borrowers
number of borrowers - defaulting borrowers = 100 - (100 x 5%) = 95
Amount owed per paying borrower
$110,000 total loan amount / 95 paying borrowers = 1,157.89
Interest charged per borrower
$1,157.89 amount owed - $1,000 original loan amount = $157.89
Each of the people who repay the loan will be charged $157.89 on top of the original loan amount to cover the lender's profit on their own loan as well as a portion of the principal and profit of the 5 people who defaulted on their loans.

Now let's look at another example where all of the numbers are the same except that each person in the new group has a bad credit score. Instead of a 5% chance of default, the risk is 20%. Going through the math again, you can start to see how bad credit costs consumers.
Total loan amount
100 loans x $1,000 per loan = $100,000
Lender profit
$100,000 total loan amount x 10% profit = $10,000
Total amount repaid to lender
$10,000 profit + $100,000 total loan amount = $110,000
Number of paying borrowers
number of borrowers - defaulting borrowers = 100 - (100 x 20%) = 80
Amount owed per paying borrower
$110,000 total loan amount / 80 paying borrowers = $1,375.00
Interest charged per borrower
$1,375.00 amount owed - $1,000 original loan amount = $375.00
As you can see, the amount paid by each borrower is much higher in this second example. And, as is the case with the good credit group, once again it is the people who repay their loan that have to foot the bill for those who do not.

And here enters an unfortunate truth of the credit scoring system. While it is the people with lower credit scores that get punished in the form of being charged more for the privilege of using credit, it is only those who are responsible and pay their bills that truly get affected. And as for the lenders, as long as they practice a reasonable amount of lending discretion (something recent history has taught us is not a given), it makes no difference whether they lend to a group of people with good, average, or poor credit score. They get their money in the end.

Getting a Better Group of Peers

Most people are not a credit risk. Even in the bad credit group above which represents an extremely high rate of default, the large majority of people could be counted on to pay back the loan.

As stated above, even if you have a bad credit score, you are probably a responsible, hard working person who will use credit responsibly. It's just that when you take a lot of people with your same credit score, there are more deadbeats in that group than there are in a group of people with a high credit score.

Increasing you credit score means you start getting grouped with fewer deadbeats that you have to cover for which means more of your money ends up in you pocket instead of making up for someone else's shortcomings.