CHAPTER 5 Why So Little or So Much Interest?

What determines the interest charged? Although there is a lot of diversity into what different lenders consider when deciding the niche areas that they decide to play in, one will find out there is a lot more continuity in determining the risk. That basically means that two lenders may agree on your risk profile, and one takes you and the other doesn’t for the reasons mentioned earlier concerning whether or not it is in the area that they would like to play in.

However, many people’s understanding of what determines the amount of interest charged is wrong because they are not looking at this from a lender’s perspective. There is no moral arbiter in terms of interest, just the calculation of what the risk profile is, and what amount of interest would justify that risk level. This is why I tell people that their situation usually has more to do with the interest they pay than the actual lender. The best example I can use for interest is the way you invest for retirement. If you have a financial adviser, one of the first questions they ask you is, “Are you looking to invest in something with a higher return and higher risk, or something safer with lower return?” Usually, the advice given is that the younger you are, the higher risk/return one should seek. The older you get the more one should be changing to a lower risk, lower-return investment choice. Well, in the verisimilitude of the way you approach your investments is the same way that lenders approach lending you the funds needed for your business. If you are a low risk, then you would most likely be eligible for a lower interest loan and vice versa. Your risk is determined by the three C’s: credit, collateral, and cash flow.

Essentially, interest rates are the costs charged after borrowing money by the lenders. On the lenders’ perspective, interest rates are a sort of compensation for the actual service as well as the risk of loaning money. In both extremes, interest rates ensure that the economy is kept in motion through encouraging people to spend, lend, and borrow. This said, however, interest rates almost always keep on changing, with different kinds of loans requiring different interest rates from others. Whether one is a borrower, lender, or both, it is imperative to have some bit of comprehension underlying the reason why different loans attract different interest rates. This chapter aims at reviewing the various determinants that lenders take into account when calculating the amount of interest to charge a borrower.

As rule of thumb, lenders will usually first determine the level of risk a borrower poses to their loaned finances. One example in the inverse, when investing in a retirement investment portfolio, a young investor would be considered for a high risk and high return investment in comparison to an old investor, who is in most case advised to opt for low risk and low return investment. The same holds when calculating the amount of interest rates to be charged by lenders. A borrower with a relatively low level of risk is considered for a low interest loan, while a borrower with a relatively high risk level will automatically be charged more interest. The rationale behind this is that for a borrower with a high risk level, they pose a relatively high default risk, hence the high interest rate. On the other hand, a borrower with a low risk level will most likely be not a significant risk to default remittance to the lender, therefore being charged a relatively low interest rate.

This notwithstanding, lenders employ other major factors when deciding on the amount of interest rates to charge borrowers. The three C’s is a trifecta often employed by lenders in calculating interest rates. The three C’s model represents credit, cash flow, and collateral. Together, these factors are scrutinized deeply by the lending institutions. In so doing, different borrowers are classified under different risk levels, hence the different interest rates. This model has been adopted by banks as well as other lending institutions, as it enables them to conduct both a quantitative as well as a qualitative measure and estimate of a borrower’s creditworthiness.