Risk and Interest – How They Affect Your Future
Christopher Shank NMLS 2562885
“Hey Chris, thank you for talking with me about VA construction loans. In our conversation, you mentioned things like preferential pricing and how my credit factors into my interest rate. Can you go into a bit more detail about how that works?”
Brother (you know who you are), I told you that I was going to turn our conversation into an article, and by God, I keep my promises.
Despite what you may hope, the company that lends you the money you need to buy a car or a home is not doing it out of the kindness of its corporate heart; they’re lending you money so that they can make money.
When an organization lends you money, they’re banking on the fact that they’re not only going to make all of their money back at the end of the day, but that they’re going to make a little extra on the top, for their efforts. This extra is called “Interest”, and it’s (in my opinion) the most important financial concept that you will learn about in your life.
Say, for example, you decide to purchase yourself a car for $20,000. You work with your local financial institution, and agree that you will pay your loan back over the course of five years, and will pay 6% interest annually on top of your principal payments. By the end of your loan, you will not only have paid your financial institution back the $20,000 they initially lent you, but you’ll be paying around $3,200 in interest payments through the life of that loan. In this instance, I like to think of that interest payment as the cost to me for not having that $20,000 available in the first place.
Ready for another one? Say, this time, instead of buying yourself a $20,000 car, you want to instead borrow money to buy a $500,000 home. For the sake of simplicity, say you manage to grab yourself a 6% interest on your 30 year loan. At the end of those 30 years, if you make your regular, minimum payments, you’re looking at paying about $580,000 in interest- that’s in addition to the $500,000 you’ve paid back in principal.
Crazy, huh? As a rule of thumb, the longer you’re paying on a loan, the more you can expect to pay in interest at the end of the day.
“But Chris, what determines interest rates, anyway?”
There are many different factors that go into interest rates, but I think it’s simplest to divide them into two groups: factors that you can’t control, and factors that you can control.
There are many things that you, an individual, have absolutely no control over. Most lenders tie their rates, in some way, shape, or form, to one market index or the other. Changes in the stock market or differences in the value of the US dollar will have a direct result on the interest rates that lenders are willing to offer. Other factors, such as inflation, current employment indexes, and even economic or political turmoil (or even the potential for turmoil) have (and likely will continue to) influenced interest rates for as long as people have bothered to record those numbers.
Additionally, many lenders will have their own indexes as well. If a particular company is trying to capitalize on some quick growth, they’re likely to reduce interest rates to incentivize new customers to invest with. On the other hand, if a company is performing in the red, they could increase rates in an attempt to increase their profit margins a bit.
Like I said, the above factors aren’t things that you, a single individual, will likely be able to control. Yes, you could certainly shop around for a different lender, but you’re probably not going to be able to influence that lender’s policy when it comes to their pricing structure. That said, there are factors about your interest rates you can control- your financial foundation, and your collateral.
“Financial Foundation? You say that a lot. What is it?”
Back when I was a junior enlisted Marine, I did not have the grasp of finances that I have now. In fact, I was so bad at managing money that I lived paycheck to paycheck, oftentimes using my personal credit card to cover the spread. After my last vehicle gave up the ghost, I went to a local dealership to buy myself a new car. The brand new models were a little outside my price range, but I found a used Nissan Juke for around $15,000 that I could manage. I remember waiting anxiously in the lobby of the dealership’s finance section, feeling a lot like a student waiting for the principal to give me detention. The problem was that a credit check revealed my score to be in the 400’s, and that dealership’s loan officer was having a difficult time finding someone willing to lend me the money I needed to buy that car. Thankfully, his search proved fruitful, and he connected me with a company that was happy to loan me that fifteen grand, and it would only require me agreeing to pay them back at 28% interest.
Yeah, I still cringe thinking back at that number. The problem was that my credit history did not paint me in the greatest light. Think of it this way- say an acquaintance of yours asks to borrow a thousand dollars from you. If you know this person has a bad reputation for not paying people back for the money they borrowed, and he already owes quite a lot of money to other people, how likely are you to give him that money?
I was no different. Missed payments and high balances on my credit lines were clear indications that I was poor with managing my finances. Statistically, there was a high likelihood that I would either miss payments or outright fail to pay back the money lent to me. Whenever this happens, lenders lose money. Have you ever been contacted by a lender about a late payment? Even if that missed payment was a mistake and you pay that money immediately, the lender still had to pay someone to reach out and get that money, which is usually an expense that they don’t count on when deciding the profitability of an investment.
Every lender out there has something called a “risk appetite”, which is a term that sums up how willing they are to accept specific levels of risk. The lender that I secured my vehicle loan from had a specific risk appetite toward buyers with credit problems. This is because that particular company had a, shall we say, “sizable” debt collection and repossession department. They accepted the fact that by lending to this particular population of borrowers, they were bound to go after at least a few of them for not paying their bills, and have planned accordingly. The other lenders my auto loan officer had approached on my behalf did not have such a risk appetite, so they passed on the opportunity to do business with me.
As I’ve said, lenders make their money from successful investments, and in order to do so, they look at the qualifications of borrowers to determine how likely an investment into that person is to succeed. As a rule of thumb, a high credit score indicates a borrower who manages their finances well and is less likely to cause that company financial loss. To incentivize these types of qualified buyers, lenders will often offer preferred rates or other discounts.
Simply put- if you want to get a better interest rate, work on building yourself a strong financial foundation. The specifics behind this process are quite detailed, so I’m going to save them for a future article. Instead, my quick advice is as follows:
1. Don’t miss payments. 35% of your credit score is comprised of your payment history, and even a single late payment can be a red flag that a lender will use to price against you.
2. Keep your credit utilization no higher than 50%, but ideally under 15%. The closer you are to the limits on your credit cards, the riskier an investment you seem to a lender. Think of it like this- if you owe $100 to three different lenders, but only have $200 to spare, somebody is being left in the cold. Lenders aren’t fans of those odds.
3. Be mindful of your credit score. Get yourself a credit monitoring app through either a third party service or your financial institution. A few months ago, a client of mine noticed an unanticipated credit drop of 40 points. She responded quickly and discovered that she had been the victim of identity theft. Trust me, it’s much better to be mindful of your financial standing and find out about something like identity theft on your own, rather than when you’re already halfway through the financing process and you’ve got a car or a home waiting on a clean bill of financial health.
“You mentioned Collateral. What is this?”
Collateral is something you put forward as a security on a loan. If you fail to meet your side of the bargain, your lender has the right to take ownership of that collateral. In the world of lending, collateral typically takes one of two forms- down payments, or secured property.
A down payment is an amount of money that you agree to contribute toward the pool of money that will be used to make your purchase. For example, when I purchased that car in the above example, I agreed to put forward a down payment of $1,500, with my finance company ponying up the remaining $13,500. Many lenders prefer down payments, because they usually indicate that a borrower is confident enough in their decision to secure a loan, that they’re willing to put their own money into the mix.
Secured property assures the lender that, should you fail to uphold your end of the deal, the lender can step in, take ownership of the property that their money purchased in the first place, and liquidate it to make up for some of their financial loss. Had I failed to keep up with my car’s payments, my lender would have happily repossessed my car, sold it, and then stuck me with a bill for any remaining amount of the loan the sale of my vehicle didn’t cover.
Collateral helps assure your lender that you’re serious about the deal you’re about to make, or at the very least, allays their fears that, should you fail to keep that deal, they’ll have a major loss that they need to account for. Because of this, collateralized loans oftentimes have interest rates preferable to noncollateralized loans.
Want an example? Look no further than credit cards. Right now I’ve got a card from a major financial institution that I use for all my Amazon purchases. 28.9% APR- yikes. Here’s the thing, though- my credit card is a non-collateralized line of credit. If I decide to simply stop paying my card, that credit company has to pay someone to harass me with late payment calls. Eventually, that company is going to have to cut their losses by selling my debt to a collections company for pennies on the dollar. To account for that risk, my credit company charges me a high interest.
It all goes back to that risk appetite I mentioned in the last section. A year or so ago, I took a personal loan to cover some wedding expenses that I didn’t want to throw on a credit card. Now, the institution I used to back this loan was the credit union I’ve been using since I enlisted, but even then, because this loan is unsecured (read: noncollateralized), I still locked in my loan at a 15% over five years.
Not to plug a future article or anything, but this is why HELOCs are so hot right now. By collateralizing a line of credit against the equity in your house, lenders are comfortable with the idea of lending on single-digit interest rates. Personally, I plan to open a HELOC on my own house as soon as I have enough equity saved up so I can stop getting run over those 29% interest coals.
It’s all about Risk
By this point in our conversation, my friend was totally flagging from some information overload (heck- you probably are, too). Don’t worry- I’m almost done.
As I mentioned earlier, lenders are investors. They may not make the crazy gains that you could by some savvy penny stock manipulation, but they also are a lot less prone to serious losses, as well. Seriously- that car I financed at 28%; had I rode that loan out to its full five years, I would have paid around $11,000 in interest for borrowing $13,500. Personally, I wouldn’t mind doubling my money every half decade!
Being investors though, lenders are very cognizant of the concept of risk, and as they have the money that you need, they have a lot of power when it comes to hedging against loss.
Best advice that I can give you is to get curious. There are folks, such as myself, who live for financial discussions such as this, and would be more than happy to delve further into these concepts with you. After all, what’s the whole point of gathering all this knowledge if there’s nobody to share it with?
