Compensation for the additional risk

The key for the lenders is the compensation for the additional risk. They simply up the fees and rates to the point that it more than covers the default probabilities. This is one reason why PhD’s and others that are involved with default probabilities are so in demand. If you can build a model that will quantify the risk in such a way you can assign a rate to it, the firm can then make money off of anyone, opening up an entire new business segment.

Of course, for the borrowers, this is a very interesting development. They used to be stuck for loans with bad credit as they just weren’t available. Now they are available and the market is becoming competitive. Hard to imagine a company vying for the business of a bad credit risk, but if the fees and rates are high enough (the rewards) it’s worth taking the chance (the risk). As with just about everything else in finance, if the risk is worth the reward, someone will take it.

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