Risk-Based Pricing: What it Means, How it Works

What Is Risk-Based Pricing?

Risk-based pricing in the credit market refers to the offering of different interest rates and loan terms to different consumers based on their creditworthiness. Risk-based pricing looks at factors associated with the ability of the borrower to pay back the loan, namely a consumer's credit score, adverse credit history (if any), employment status, income, dent level, assets, collateral, the presence of a co-signer, and so on. It does not consider factors such as race, color, national origin, religion, gender, marital status, or age which is not allowed based on the Equal Credit Opportunity Act. In 2011, the U.S. instituted a new federal risk-based pricing rule which requires lenders to provide borrowers with a risk-based pricing notice in certain situations.

Risk-based pricing may also be known as risk-based underwriting.

Key Takeaways

  • Risk-based pricing is generally based on credit history.
  • Lenders must provide notices of specific terms.
  • Debt-to-income, credit scores, and other metrics are factors in risk-based pricing.

Understanding Risk-Based Pricing

Risk-based pricing has historically been relied on in the credit market as an underwriting methodology for all types of credit products.

Risk-Based Pricing Methodologies

Lenders customize their risk-based pricing analysis to include specific parameters for borrower credit scores, debt-to-income, and other key metrics used for loan approval analysis. Lenders across the industry will have varying risk tolerances and loan risk management strategies. These strategies can dictate the parameters and borrower risks they are willing to take on.

In risk-based pricing, lenders offer borrowers loan terms based on credit profile characteristics. These characteristics are identified in a borrower’s loan application and analyzed through risk-based pricing technologies and underwriting procedures. Generally, lenders will focus the risk-based analysis on a borrower’s credit score and debt-to-income. However, lenders also closely consider all of the items on a borrower’s credit report including delinquencies and any severe adverse items such as bankruptcy.

Risk-based pricing methodologies allow lenders to use credit profile characteristics to charge borrowers interest rates that vary by credit quality. Thus, not all borrowers for a single product will receive the same interest rate and credit terms. This means that higher-risk borrowers who seem less likely to repay their loans in full and on time will be charged higher rates of interest while lower risk borrowers who seem to have a greater capacity to make payments will be charged lower rates of interest.

Risk-Based Pricing Rule

Throughout history, risk-based pricing has been known as a best practice with little regulatory intervention. However, in 2011, the federal government implemented a new risk-based pricing rule which provides for greater disclosure and transparency of the credit decision process for borrowers. Under the risk-based pricing rule, a financial institution that approves a loan or credit card for a borrower with a higher interest rate than what it charges most consumers for the same product must provide the borrower with a risk-based pricing notice. This notice can be delivered by oral, written, or electronic communication.

The risk-based pricing notice explains to the borrower that the interest rate they received was comparably higher than other borrowers approved for the loan product and also details the specific factors used by the lender in determining the higher rate. If required, this notice must be given to the borrower before they sign the product’s credit agreement. This regulation aims to preventing bias in the credit market, unfair market practices among borrowers and level the field and access to credit and avoid predatory lending.

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