The primary concern for lenders is reducing or eliminating risk. ‘Risk’ is a sometimes ill-defined term; it is basically the exposure of a lender to the financial irresponsibility of the borrower. Since the entire lender-borrower relationship is built on a long-term time scale, risk is essential to understanding how the lending markets work.
Say someone borrows one hundred dollars from a lender. Those one hundred dollars can be thought of in traditional mercantile terms as the ‘good’ of that lender. Like all goods, as customers borrowers pay a price for receiving that good. This price is the interest rate on the one hundred dollars. Like all prices, the price of a loan varies according to economic conditions.
The difference between other goods and loans is that the loan is a temporary good that must be given back, along with the loan’s price. The original loan is referred to as the principal, while the accrued price is appropriately called the interest. The borrower is called upon to pay back both the principal and the interest at a specified later date. That is the relationship between borrower and lender; understanding that relationship helps one gain an appreciation for the economy that may help in understanding other areas as well.
For instance, credit is another ill-defined term, but it also refers to the relationship between borrower and lender. A borrower’s credit rating refers to a numerical score used to judge the borrower’s ability to pay back the principal and interest of a loan. If the borrower’s credit rating is bad, lenders will not advance money to the borrower under any circumstances, since the bad credit rating tells the lender that they put their money at a huge risk by lending to this individual.
When speaking of debt instruments like a home equity loan, bad credit actually does not stop a borrower from obtaining such a loan. This is because of a crucial distinction to be made between secured and unsecured loans. A home equity loan is a secured loan because the principal and interest are pledged against a tangible asset the lender can seize if the borrower defaults.
That being said, having a bad credit rating will definitely not make the borrower look good in the eyes of potential lenders. There are ways the borrower can offset this, however. Saving enough money for a large down payment on the loan, say sixty to seventy percent of the principal, will show at least partial financial responsibility to the lender.
Another way the borrower can improve their chances is to get a co-signer on the loan; the co-signer’s good credit will even out the impact of the borrower’s bad credit.
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