Risk-based pricing is a way for lenders to set prices according to risk. If a borrower is considered risky, risk-based pricing leads that borrower to pay more in the form of a higher interest rate and cost of debt, resulting in a higher total amount paid for the borrowed money. Learn more about this form of pricing, including the pros and cons, with the following overview.
The Price Risky Borrowers Pay
What exactly is a high or low price? For most loans, you pay interest in return for the ability to borrow money. With risk-based pricing, you pay more or less interest depending on the lender's evaluation of the risk they would be exposed to by lending to you. If you’re a safe bet and the lender is all but certain you’ll repay, you’ll qualify for the best products and lower interest rates.
However, if you've had some financial red flags in the past seven to 10 years, such as late payments, a foreclosure, a bankruptcy, charge-offs, etc., you will likely not get the best interest rate. If you have a good credit history, but your income is marginal, you may also be considered risky.
Risk-Based Pricing Factors
Lenders look at a variety of factors when evaluating risk. Your credit is an important part of any risk-based pricing decision. But lenders may look at many additional factors such as loan-to-value (LTV) ratios, debt-to-income ratios, and any other factor related to your overall financial picture and current obligations since these can affect your ability to pay back the loan or their ability to collect in case of default.
For example, the length of time you've worked at your job can make you appear more or less risky. Some lenders also want to know how long you've lived in your home. In some cases, individuals who've lived at their residence for fewer than three years or have a history of bouncing from one home to another may also be considered risky. Stability in employment and residence all make a borrower less risky.
Is Risk-Based Pricing Fair?
Risk-based pricing is criticized by some as a predatory practice. Instead of denying credit to people who don’t qualify and shouldn’t borrow, lenders can just charge extremely high prices. Unsophisticated borrowers don’t know that they have bad credit, and they don’t know what it costs them.
More importantly, the U.S. economy is changing and over 9 million Americans are expected to be working in the gig economy in 2021. Lenders looking unfavorably at those who change jobs and have no full-time job status will present a disadvantage to this category of the workforce for their cost of debt.
On the other hand, risk-based pricing gives people an opportunity they otherwise would not have had. Instead of being denied, they’re told "you can borrow, but it’ll cost you." If everybody is aware of how the system works, it seems fair enough. Regulators want to be sure that borrowers understand when they pay more under risk-based pricing, so they now require lenders to notify borrowers who pay higher prices.
Consider a case where you want to buy a home. The Federal Citizen Information Center provides an example in the publication "Your Credit Score." Borrowers with bad credit pay 3 percent per year more (in terms of APR) on their loan than borrowers with good credit, leading to a higher monthly payment and larger lifetime interest costs. Interest rates constantly change, but you can get up-to-date numbers at MyFico.com.
To see how your loan might be affected, find out how your interest rate would change with a different credit score. Then, use a loan amortization calculator to see how your monthly payment and interest costs would change. Now you can put a price on good credit.