Paying Less Interests on Consumer Loans by Lending Guarantees
Interest rate on a consumer loan fluctuates importantly with the credit risk. The interest rate is partly calculated on the risk of loss in the event that the borrower wouldn't reimburse his loan. However, banks and financial institutions offer lower interest rates in exchange of guarantees. This policy is applied mainly on high loans, such as a car loan or a mortgage. In those two cases, the bank is not secure enough with the applicant's credit record only, so they include the financed good in the transaction to reduce the risks of loss if ever the client stops paying.
When taking the collateral as a guarantee, the lender institution seek to reduce his risk, and in the event that the consumer would not reimburse his loan, the bank or the financial institution will seize the financed good and resale it on the market to repay itself from the loss related to the unpaid balance. Since the risk of loss is lower with guarantees, bank charges a lower interest rate.
Cars and other type of vehicles (ATV, boat, snowmobile...) can be taken as a guarantee when financed. When financing a vehicle, the calculation of a possible loss for the bank can follow this scenario: if, for example, the balance of the loan is 10,000 and its value is 8,000, then, in the event that the client would stop paying his loan, the financial institution would record a loss of 2,000 with the vehicle as guaranty as opposed to 10,000 without guaranty. Consequently, banks can reduce their risk of loss and charge a more competitive interest rate, to the advantage of the consumer.
However, automobiles and others vehicles are not guarantees without flaws since they lose value with time and it is difficult to predict exactly how it will devaluate. Therefore, banks and financial institutions request from consumer with bad or average credit report to put a down payment or a security deposit on the transaction in order to have a balance that will always be close to, or under, the market value of the vehicle. The cash down and the security deposit are considered as an additional guarantee.
Car industries like Ford, GM and Toyota often offer financing and renting services, due to the fact that they have good expertise in the car market. They know how a vehicle devaluates and they structure the loan consequently. This expertise and knowledge explain the extremely low interest rate (sometimes 0%) we find in dealership that provides financing and renting services. That is why it is always better to do business with dealership than with banks or other independent institutions when it comes to financing or renting new vehicles.
Mortgages give very large credit to consumer willing to finance their house. They are very popular because it is rare to have someone being able to pay his house cash. When the loan is attributed to the consumer, the bank take the residence as a guarantee until the mortgage is paid in full.
As opposed to vehicles, houses gain value with time. However, banks still look for a down payment. Why? Because the value can be overestimated, the house can devaluate during economical crises and taking hold of a residence always brings extra costs (lawyer, resale in the market, opportunity costs...) Plus, the borrower mostly pays interests at the beginning of the term, which explains the slow decrease of the balance at first. These factors motivate banks to ask for minimal cash down of 5% in most of the cases when a consumer applies for a mortgage.
Since houses are guarantees that are very safe, the mortgage rate represents the smallest rate for borrowing. The consumer, if there is equity on the house (market value of the house minus mortgage balance), can exploit this rate by using the house to secure a line of credit. That way, lending your house as a guarantee to banks gives you the best interest rate, and it is then possible to transfer all your debt on that line of credit and pay the least interests possible. Also, the consumer can use this line of credit for other personal financing, like renovations.
Co-signer and Cash Down
A way for consumer to exploit low interest rate is to get a co-signer. When this happens, the co-signer acts like a guarantee; if the first signer stops his payments, the co-signer becomes responsible for the payments. The credit risk is then based on both consumers. It is often a beneficial option for the consumer that does not qualify alone for low interest rate loans.
Another way to have access on low interest rate is to provide a generous down payment on the financed good. If the consumer credit rate is low, the financial institution secures itself with the equity obtained on the collateral. For example, if a house is worth 300,000 and the borrower makes a deposit of 100,000 on it to finance 200,000, the risk of loss is considerably reduced because the value of the house will always cover the unpaid balance in case of repossession.
Interest Rate without Guarantees
The value of the collateral is a way for the financial institutions to reduce its loss in case of payment default, which make it possible for them to charge lower interest rates. However, if there is no collateral as a guarantee, the financial institutions charge a higher interest rate, which is the case for credit cards.
With an interest rate that reaches almost 20% on credit cards, and even 30% on some retailer's credit card, if the client stops his payments, the bank or retailers would have made enough money with the high interest rate that they would have cumulated enough profits to surpass the loss associates with the unpaid balance. The high interest rate becomes the guarantee itself. This technique explains the easy accessibility of credit cards today, and it is the most expensive way for the consumer to borrow money. It should be more used as a transaction tool than a financing product.
Consumers with a good credit report normally operate with a line of credit or personal loan. The interest rate from line of credit and personal loan are normally half of the one of credit cards; it can then be used as financing products. These products are based principally on the credit report of the individual, but the line of credit can always be guaranteed on the house. If it's secured on the residence, the interest rate will be much better for the consumer.
This covers what banks and financial institutions search in terms of guarantee when opening a consumer loan. It is important to always verify if a debt can be transferred to a lower interest rate. If the consumer has the intention to make his payments, giving guarantees doesn't change anything in his everyday life and it lowers the costs of debt. That way, the capital portion of the payments is higher and the interest portion is smaller, which, in the end, reduces the payment effort.