Why Do Lenders Charge a Premium on Loans?

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Loan premiums can make a loan cheaper or more expensive.
Loan premiums can make a loan cheaper or more expensive. (Image: sign. loan sale image by L. Shat from Fotolia.com)

A premium on a loan is an additional fee paid by one party to entice the other to enter the agreement. Typically, a premium is charged by a lender when the borrower poses a substantial default risk.

Example

A borrower has a credit rating below 650, putting him in the medium risk category for a mortgage. A bank denies the loan, but a high risk mortgage lender offers the financing with an adjustable interest rate. The rate adjusts at a premium of three percentage points above the prime rate, making this loan more expensive for the borrower in exchange for the lender's risk.

Expert Insight

Any time a premium is charged, the lender is stating it needs additional incentive if the borrower would like to secure the loan. You may offer alternatives to a premium, such as placing a higher down payment or buying insurance on the loan, which can remove the necessity for the premium and reduce your expense.

Alternate Types

Not all premiums are charged by lenders. For example, if a borrower agrees to take a very large loan with a high interest rate, the borrower may ask for financial incentive in the form of a premium beyond the principal of the loan. This model can be used in very large commercial loan transactions where lenders bid to provide the company its costly financing.

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