“High risk, high reward,” as the old saying goes, should really be “high risk, higher premiums.” Any time you investing money or borrowing it in the form of a loan, the likelier the entire principal balance will not be returned, the more likely the pot will need to be sweetened. The higher rate associated with a risky investment is known as the interest rate risk premium, while the expensive interest rate you pay as a risky borrower is the debt risk premium.
In essence, the investor or creditor is charging an additional rate of return on top of the principal and original yield due to higher risks associated with the investment or debtor.
When a Debt Risk Premium Can Cost You
An instance of how a debt risk premium when people with low credit scores are charged higher mortgage rates or credit card interest rates because they carry more risk than someone with excellent credit. That is an example of when risk premiums can work against you. However, they can also work in your favor, assuming that it actually pays out and doesn’t default.
Advantages of the Interest Rate Risk Premium
Another example of an interest rate risk premium is the higher yield on certain bonds. Healthy companies pay out bond yields that are lower than companies at risk of default or young start-ups that don’t have an established track record.
This is done to attract bond buyers willing to take on a riskier investment, since there is a higher chance of not getting the money money back. They are rewarded for this increased risk with a higher return on their investment. This basic principle is the same with most investments.
For example, let’s say you know two people who want to borrow $1,000 from you. Person A is always reliable and you know you’ll get your money back if you lend it to him. Person B isn’t as reliable. Sometimes he pays it back, sometimes he doesn’t. All things being equal, you’d lend the money to person A, right?
What if Person B says he’ll pay you back your $1,000, and an additional $200? That $200 serves as the risk premium. Would you risk losing some or all of the $1,000 to make $200?
It’s difficult to tell exactly how the interest rate risk premium is determined, but what’s most important is studying up on the historical performance of the debtor or investment. Its track record is probably the most telling sign. Depending on your situation and financial goals, risk premiums could either yield you higher returns or cost you more in interest payments.
