How Does a High Risk Loan Work?

The Bank Assesses The Loan Risk

When a borrower applies for a loan, the bank will ask certain questions designed to assess the applicant's ability to repay the loan. These questions might include inquiries about monthly or annual income, monthly expenses and how long the borrower has been consecutively employed. In addition, the bank will likely obtain a credit report from a credit bureau to determine how well the applicant has repayed other loans in the past.

The Bank Assigns a Risk Factor

Once all of the information is available, the bank assigns a level of risk to the borrower. Applicants who have a high credit score (indicating they have repaid other debts on time in the past) and who seem able to make timely payments are determined to be low risk. Applicants who have low credit scores, spotty or poor performance on past loans, no borrowing experience or who appear to jump from job to job may be declared a high risk. The bank uses the risk assessment to determine if it is willing to loan money to the applicant and, if it does, how much interest would be appropriate.

The Bank Determines and Negotiates the Interest Rate

Once a risk factor is determined and a decision to loan money has been made, the bank bases its interest rate on the factors included in the risk assessment. While the bank does have a minimum interest rate required to produce a profit (a profitable interest rate must be more than the interest the bank pays to its own lenders), the interest rate goes up in proportion to the risk. Very high risk borrowers may pay interest rates at or above 20 percent, increasing the potential profit which may be realized by the lending institution. Many banks also structure their loans to receive their interest in the beginning of the repayment, leaving the borrower responsible for a larger sum if he should default.

Some banks also allow the borrower to negotiate down the interest rate by offering some form of collateral. Under this arrangement, the borrower gives the bank a stake in some tangible property such as a car, a home or some other item of value. The bank reduces the risk assessment of the customer as it can retrieve and sell this item should the borrower default.