When you apply for a loan, you don’t automatically get the typical interest rate that’s advertised. For most loans, lenders use risk-based pricing methods to determine what interest rate you pay. Different borrowers get different rates depending on the level of risk to the bank. This type of pricing applies to all types of loans these days, including mortgages, auto loans, personal loans and credit cards.
Risk-based pricing uses a number of different factors to determine the probability of a borrower defaulting on the loan. If your probability of defaulting is high, you will have to pay a higher rate to justify the added risk. If your probability of defaulting is very high, you will probably be denied for the loan altogether.
In the past, those who were considered high credit risks were simply denied credit. Credit approval was more of a yes-or-no proposition. The introduction of risk-based pricing allowed more borrowers to qualify for loans so long as they were willing to pay for it in higher interest rates and additional fees. Now, credit is once again tightening.
While different lenders use different models to assess risk, the basic principles and mechanisms are usually constant. Most risk-based pricing models use a typical base rate for a loan. Your particular risk factors are then evaluated to determine if you will be charged an additional cost for the loan or given a rebate on the price of the loan. The main factor that is considered when assessing risk is your credit history.
Lenders categorize credit scores into ranges and apply costs or rebates to those ranges. For example, a FICO score of 740 or above is now considered the highest tier. Borrowers with credit scores in that range would be given a rebate over the typical rate of 0.25%, for instance. Someone with a credit score in a lower range, such as 660 to 679, might be charged an added cost, say 0.25% on top of the typical rate.
Your credit score is not the only factor that is considered in risk-based pricing models. Additionally, debt-to-income ratio, employment status, marital status and other personal factors are usually examined. The specifics of the loan also make a difference. For a mortgage, these include the loan-to-value ratio, the loan amount, the location of the property and the type of property.
Loan-to-value ratio is usually the most important of these factors. The size of your down payment will affect your interest rate. The larger your down payment, the lower your interest rate because the lender will have less to lose if you default on the loan.
Risk-based pricing doesn’t only come into play when you apply for a loan; it can also affect your interest rate throughout the loan. This is most common with credit cards. Credit card issuers now make regular practice of checking cardholders credit reports periodically. If you have late payments to the issuer or to other creditors, it could trigger a substantial rate hike using the universal default clause. (Luckily, new credit card legislation which will go into effect in February eliminates universal default.)
The surest way to lower your risk factors, so you can get low interest rates, is to pay your bills on time and maximize your credit score. Even a single late payment can end up costing you big in higher rates.
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