How do you look (to a bank)?

It literally pays to think like a finance guy sometimes. 

Picture this true story: I’m working for a US bank, sitting in a sales meeting, and the sales manager is running about 30 of us through the new pricing on mortgages. As usual, it’s lower rates for those with a cleaner credit record; higher rates for those with a less-pristine history. Much depends on the borrowers’ credit scores.

Sitting near me is last year’s top seller – this guy had pulled down more than $900,000 in commissions that year. He was king of the hill.

He suddenly blurts with more than a hint of sarcasm: “Oh, so once again, poorer people are getting charged more.” Cue uncomfortable fidgeting and sniggering around the room.

Just a fleeting moment, then it was quickly back to business as usual. As I said, he was king of the hill, so he could say what he wanted. (Apparently he had a social conscience, too.)

Why do people who struggle to make ends meet end up paying higher rates? Here’s where it pays to think like a lender. The idea is, if you’re lending and a borrower poses more risk to you, you should be compensated for taking them on, in case of future losses. And one way you do this is by charging them higher interest rates.

This is why, as borrowers, submitting a loan application is very much like handing over our CV when we go for a job – we all want to be putting our best foot forward. Monitoring our credit reports and making sure they accurately reflect our history is worth doing.

But does it have to be this way?

All this makes me think of the debtors’ prisons that Charles Dickens wrote about, where people were cast when they couldn’t repay. With the benefit of hindsight this seems absurd – throw people in jail, so they can’t work and repay their obligations? Perhaps the idea was that borrowers would be so scared of the prospect of jail that they would be sure to repay. However, the many thousands who suffered these prisons proved that the idea didn’t work.

Of course it’s easy now to criticise that extraordinarily bad idea. But what are the things we do today that the future will also judge harshly?

The practice of lenders charging poorer borrowers more in order to cover themselves could fall into this category. What this does is shift the risk from lenders to borrowers – the very people who are worst placed to absorb it.

If you look at the way compound interest can work against us instead of for us, the end result is that more vulnerable people get charged more and can spiral into overwhelming debt. The treadmill of debt accelerates, without anyone pushing the “go faster” button.

We’ve effectively made it more difficult for people to get ahead.

“Debt is the anti-insurance,” write professors Atif Mian and Amir Sufi in their book House of Debt. “Instead of helping to share the risks associated with home ownership, it concentrates the risks on those least able to bear it.” To avoid another GFC, one of the things they propose is new mortgage contracts that are built on the principle of risk-sharing.

In the meantime, we’ll need to keep putting our best foot forward to get the best rates we can when we borrow. Which is why it pays to remember how we look… to a lender.