Why would a lender raise interest rates if you are in danger of not being able to pay your loan?

Question

This is a follow-up to this question. It is established that lenders charge higher interest rates to customers less likely to be able to repay their loan in full, but this increased rate shouldn't affect the borrowers ability to pay much because they will be loaned a lower amount.

But what about the case where the lender increases the rate after the loan is already established? For instance, if a borrower is 60 days late on paying their credit card, the credit card company can impose a penalty APR of 29.99% which applies to the existing balance. But why would they do this? If the borrower is having trouble making their payments - say they lost part of their income and their cash flow is marginal, then an increase in interest rate is going to increase how much they have to pay, and could push them into a debt spiral they can't recover from.

Answer 1

tl;dr -- That penalty interest rate is essentially a legal technique to improve the lender's recovery rate in the event of a default. They lender uses it when they predict a borrower to be in financial distress already...and therefore highly unlikely to repay in full. I think this timing issue is the core of your question.

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The answers from @CactusCake and @D Stanley to the original question you linked to both explain a risky interest rate as compensation for the risk of the borrower defaulting on the lender.

Extend that explanation by thinking of the interest rate on any form of credit (bond, bank loan, credit card, rent-to-own, etc.) as the lender's profit margin. To be profitable, the lender has to cover their costs. The lender's expected loss due to default is one such cost, and it typically accounts for a significant portion of the credit spread (that part of the interest rate in excess of "risk-free" interest rates). reference

If a borrower is 60 days past due then their probability of default is likely to be relatively high. Apart from the common sense element of the situation, lenders rely on credit transition matrixes, which estimate the probability that a borrower will default over some period of time given their starting probability of default. related reference

Since your question is hypothetical, assume the credit card company in question is located in the U.S. where non-mortgage lenders generally have a legal claim ("recourse") against borrowers in default. The cardholder's lending agreement most likely specifies the card company's right to apply that penalty interest rate -- it may well be as high a rate as can be applied without violating usury laws. By the time the cardholder has gotten this delinquent, the card company assumes the cardholder will default. The company then applies that penalty interest rate fully expecting that they will need to pursue a legal claim to recover the past due card balance and the money value of the penalty interest rate (which they assume has a high probability of similarly going unpaid).

Further expecting that the cardholder will not have the resources to pay off the card balance in full and that the risk of cardholder bankruptcy is high, the card company's penalty interest rate is effectively boosting their legal claim from, say, $1000 to $1000 * [1 + (.2999/365 * days outstanding)]. In the U.S. -- where we assume this all takes place -- creditors with similar claims (credit card, utilities, car loan lender, etc.) are generally entitled to a pro rata share of a bankrupt person's assets based on the size of their claim.

Answer 2

Say you have 5 accounts you're making payments on, and one of them raises its rates to 29.99%. When you have a bit of available cash, which one are you going to try to pay off first? This could be viewed as a defensive move.

Also, the higher rate aligns with the fact that you are now viewed as higher risk.

Edit to add this thought:

Thinking about it more, the creditors are faced with the prisoner's dilemma. If none of them raises interest rates, you may be more likely to avoid bankruptcy and pay them all back. But if only one of them raises your rates, the others will face increased risk for two reasons.

Answer 3

In addition to Neil's point about prioritizing over other creditors, the higher rate motivates prioritizing over ordinary consumption (i.e., cutting other expenses when possible). Moreover, the (well-advertised) penalty rate may be a deterrent even before it's imposed, helping reduce the number who fall behind in the first place.

Also, pushing someone into a debt spiral at a high interest rate might still result in more total money paid to the lender (by the time the borrower is bankrupt) than the original terms called for.

But an interesting aspect of the question is that, whereas raising the rate makes sense for a borrower who is being irresponsible but can do better, lenders do indeed sometimes agree to modifications, settlements, or "haircuts" in favor of existing borrowers who they now believe can't pay as agreed. At that point, when solvency is imminently in question, the lender wants to get something rather than nothing.