why smaller and shorter-term loans have higher interest rates

why smaller and shorter-term loans have higher interest rates

Finance explained: why smaller and shorter-term loans have higher interest rates

The team at Smallloans.com.au work hard to keep your small cash loan and payday loan interest rates as fair and competitive as possible. Small cash loans and payday loans like the ones we offer do have higher interest rates compared to other loan products such as a mortgage or a car loan. If you’ve ever gone shopping for loans, you will see a trend – mortgages will have lower interest rates than car loans and car loans might have lower interest rates than personal loans. But why is that the case?

It all starts with the Official Bank Rate

As we explained in our blog on how the Reserve Bank sets interest rates and what that means for you, the starting point for all interest rates is the Official Bank Rate or the OBR. The OBR determines the base price of money in the market. But what we need to look at is the yield for loans. Please note we are only looking at the interest rate, not other fees and charges loans might have.

Interest rates + loan terms = yields

The yield for loans is how much money banks and lenders can make until these loans mature, or are paid off. Banks and lenders need to make sure their interest rate and loan terms are high enough to make a profit but also low enough that they remain reasonable. This is the nature of the marketplace.
Earning a profit from loans means banks can pay interest back into their customers’ bank accounts, give their shareholders’ good dividends and ensure that the economy is moved forward by lending out more money to families, businesses and individuals.

An interest rate scenario

Imagine if every loan had the same interest rate. Lending out $1000 at 5% annual interest only makes a profit of $50 per year. It’s very likely someone will pay back that amount in less than a whole year! A lender would either need a lot of starting capital or a lot of customers to break even. Lending $100,000 at 5% per annum over 25 years nets the bank a healthy profit. The banks use this profit to lend out to other people who might need it.

The risk factor

Of course, in a perfect marketplace everyone would have the same interest rate. But there is a factor of risk involved for banks and lenders. If you’ve had an unfortunate past with credit and have unpaid defaults or other blemishes on your credit history, lenders and banks see you as a higher risk. When they work out all the formulas and yields, it’s something they have to factor in. Just like when people have car accidents and have to pay more. These loans work on a very similar principle. The bank may lose out on a transaction if they’re not paid back on time or at all. If it’s an unsecured loan, the lender may lose the lot.

“Collateral” and securities make a difference too

We’ve explored unsecured loans in our blog on small unsecured loans. A loan without a security means there’s nothing tying the loan to an object of value. If someone simply skips out on their loan and never pays it back, the lender has to take a hit. They can’t take back thin air! This makes it worse off for every honest customer, because lenders will have to raise interest rates to recoup the costs. Loans with securities have lower interest rates because it’s tied to something.

Very long loans means more risk too

Loans with very long terms such as 50 or 60 years also may have high interest rates because there’s a lot of risk involved in these types of transactions. Who knows what will happen 5 years from now, let alone 50 years from now!