You may not have heard the term “risk-based pricing” before, but you’ve likely seen it in action if you’ve ever gotten a loan or a credit card.
Risk-based pricing is when lenders decide which interest rate and other loan terms to offer a borrower based on that person’s creditworthiness. If the lender believes you may default or struggle to make payments on a loan, for example, you’ll likely be offered a higher rate — or you could be turned down altogether. On the other hand, if your chances of defaulting are low, you can expect to be offered a more competitive rate and better loan terms.
Read on for a look at how risk-based pricing could affect your loan terms and ways to improve your risk profile in order to secure the best rate possible.
Key Points
• Risk-based pricing involves setting loan rates and terms based on a borrower’s creditworthiness.
• Factors influencing risk-based pricing include credit score, credit history, income, and debt-to-income ratio.
• This pricing model allows lenders to offer loans to a wider range of borrowers, including those with lower credit scores.
• Borrowers with better credit profiles can secure lower interest rates and more favorable loan terms.
• Regulations require lenders to notify borrowers if they receive less-favorable terms due to their credit report.
Risk-Based Pricing Explained
If you’ve ever applied for a loan or credit card, you’ve probably noticed that everyone isn’t offered the same interest rate and terms. That’s because financial institutions typically use risk-based pricing to determine how much they’ll charge borrowers for the money they lend.
What Is Risk-Based Pricing?
The idea behind risk-based pricing is fairly straightforward: Different borrowers get different rates depending on the level of risk the lender believes it’s taking. This allows financial institutions to provide options to a wide range of consumers while also making sure they’re being compensated for taking a chance on those who may be less creditworthy.
How Risk-Based Pricing Works
A key part of the loan underwriting process is assessing a borrower’s risk profile. Lenders can’t legally consider factors such as age, race, or gender when they’re deciding whether to approve a loan application. But they can — and do — use risk-based pricing models to help determine if a borrower should get a loan and if that loan should cost more or less based on financial criteria.
Lenders want to be as sure as possible they’ll be repaid on time and in full. And though there’s no guarantee a borrower with a good financial reputation won’t default on a loan, lenders typically see it as a solid indicator of a favorable outcome.
This means an applicant with an excellent credit score and other positive financial factors can expect to be offered a lower interest rate than a person with average, fair, or poor credit. This is true whether they’re seeking a car loan, personal loan, or a mortgage.
Creditworthiness can also affect loan fees and repayment terms, and the rewards and perks available with certain credit cards.
Factors that Can Influence Risk-Based Pricing
The criteria used to determine loan eligibility and pricing can vary by lender, but here are some of the factors that are typically included in a risk assessment:
Credit Score
A credit score is calculated using information such as payment history, existing debt obligations, and credit utilization from a current credit report. Lenders typically use this three-digit score as an indicator of a person’s overall financial well-being. The higher your credit score, the more likely you are to be approved for a loan and receive better financing terms.
A score of 670 to 739 is generally considered “good” on the credit rating scale, while scores of 740 to 799 are in the “very good” range, and 800 and above is “excellent.” Individual lenders may set their bar higher or lower when judging credit applicants.
Credit History
To get a more complete look at how you’ve handled credit in the past, lenders may also check one or more of your credit reports for signs of trouble. Potential red flags include past delinquencies, a mortgage foreclosure, bankruptcy, or debts that went to collection.
Income
Your income and employment history also can be a factor in determining risk. Lenders will want to see documentation that shows you earn enough to repay the loan and that you have stable employment.
Debt-to-Income Ratio
Along with your income, lenders will take a look at your debt-to-income (DTI) ratio to ensure you can manage all your debt payments. (You can calculate your DTI by dividing your monthly debt payments by your monthly gross income.) An acceptable DTI may vary by lender and the type of loan you are applying for. But in general, a DTI ratio below 43% is considered good, while many lenders prefer 36% or below.
Loan Type
Lenders tend to look at different types of debt as carrying varying levels of risk. For example, loans that are secured with some kind of collateral or down payment, such as mortgages, car loans, and home equity loans, usually come with lower interest rates than unsecured loans and credit cards.
Impact on Consumers
It may seem as though risk-based financing is all about protecting lenders — helping them minimize their losses by allowing them to tailor their rates to fit an individual borrower’s risk profile. But because it expands the range of lending options to include those with fair or even poor credit, risk-based lending can also benefit those who otherwise might not qualify for financing.
It also can serve as an incentive to consumers to improve their credit reputation in order to improve their loan terms in the future by refinancing, negotiating for a new and better rate on a current loan, or waiting to apply for financing until their credit is in better shape.
Regulations Governing Risk-Based Pricing
How can you know if you’ve been personally impacted by risk-based pricing? The Federal Trade Commission (FTC), Consumer Financial Protection Bureau (CFPB), and federal banking agencies have all published rules stating that if a lender denies a loan application or offers “materially less-favorable terms” based on a consumer credit report, it must provide the applicant with a notice that explains this decision. If you don’t agree with the terms you’ve been offered — for example, if you’re given a higher-than-expected annual percentage rate (APR) — you aren’t obligated to accept the loan.
Recommended: APR vs Interest Rate: What’s the Difference?
Pros and Cons of Risk-Based Pricing
As with most things related to finances, there are benefits and drawbacks associated with risk-based pricing.
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Pros:
• It gives lenders objective measures to assess each individual borrower’s risk profile.
• It protects lenders by allowing them to charge risky borrowers more for a loan to offset the higher probability of default.
• It allows lenders to offer a wide range of financing options to borrowers with different levels of creditworthiness.
• It can benefit low-risk borrowers, who may qualify for the more competitive rates and other loan terms a lender is offering.
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Cons:
• Borrowers who don’t check all the low- or medium-risk boxes may find it more challenging to get an affordable loan.
• It may be tempting for high-risk borrowers who need a loan to get in over their head with rates and terms they can’t really afford.
• It may be difficult for borrowers who have red flags in their credit history to qualify for a loan they can afford.
Strategies to Improve Your Risk Profile
If you’re trying to build or rebuild your credit, risk-based lending may seem unfair or even punitive. But if you keep working on your financial health, you can eventually replace the missing or negative information on your credit reports with positive numbers.
Here are some steps that can help you boost your credit profile and show lenders you’re worthy of better loan terms:
Pay Off Debt
Paying down high-interest credit card balances and lingering loan debt can help you raise your credit score and lower your DTI — two key factors lenders look at when determining a borrower’s risk. If you’re repaying several debts to different lenders, you may want to look into how debt consolidation works and whether it makes sense for you.
Increase Your Income
If a low-paying job is getting in the way of getting a loan, you might consider taking on a side gig, asking for a raise, or looking for an employer that pays more for what you do.
Monitor Your Credit Score and Credit Reports
Regularly reviewing your credit reports and promptly disputing dated info or errors can help you ensure your credit profile reflects your current financial standing. You can check your credit score for free through your bank, credit card company, Experian, or a money tracker app. And you’re entitled to a free credit report weekly from each of the three credit bureaus via AnnualCreditReport.com.
Choose Appropriate Loan Products
Think about how you plan to use the money you want to borrow and which lending product might be the best choice for that goal. If you plan to make a major purchase, for example, a personal loan might be a better option than a credit card, because interest rates are typically lower.
Recommended: What Is Risk Tolerance?
Do Some Comparison Shopping
You also may be able to save money by taking the time to shop around for the best rates and terms available for the type of loan or credit card you want. Some lenders and loan types may have less-stringent standards for borrowers than others. And while you’re looking, you can read online reviews of the lenders you’re considering.
The Takeaway
For low-risk borrowers, risk-based pricing could mean a lower interest rate and other favorable terms. For a higher-risk borrower, it can result in a more expensive loan — or the loan application being rejected. This is why it’s a good idea to know where your credit stands before you apply for any type of financing. That way, you can be an informed shopper as you look for the best rates and terms based on your current creditworthiness. Or you can work to improve your financial health so lenders regard you as less of a risk.
Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.
FAQ
How does risk-based pricing differ from flat-rate pricing?
With risk-based pricing, the cost of a loan can be adjusted to fit the creditworthiness of the borrower. With flat-rate pricing, everybody who is approved is charged the same rate, whether they have good, bad, or fair credit.
Can I negotiate better terms if I’m offered high rates due to risk-based pricing?
Whether or not you can negotiate better terms may depend on the type of loan you applied for and the lender. If, for example, you’re a long-standing customer, your lender may be willing to work with you even if you present as a high-risk borrower.
How often do lenders reassess risk for existing loans?
Because a borrower’s risk profile can change over time, lenders may periodically review a customer’s credit score, payment history, and other financial factors. How often that happens varies by lender.
Are all types of loans subject to risk-based pricing?
The rates and terms borrowers are charged for most loan types are based on risk-based pricing.
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