DEFINITION of ‘Risk-Based Pricing’
The offering of different interest rates and loan terms to different consumers based on their creditworthiness. Risk-based pricing looks at factors such as a consumer’s credit score, adverse credit history (if any), employment status and income, depending on the type of loan. It does not consider factors such as race, colour, national origin, religion, gender, marital status or age. Types of companies that use risk-based pricing include credit card issuers, mortgage lenders, utility companies, telecommunications companies and any other company that considers a consumer’s credit score before agreeing to do business with them.
INVESTOPEDIA EXPLAINS ‘Risk-Based Pricing’
Risk-based pricing allows lenders to charge higher interest rates to consumers who seem less likely to repay their loans in full and on time, and lower interest rates to consumers who seem more likely to repay their loans in full and in a timely manner. For example, if your credit report shows that you declared bankruptcy three years ago, you might be approved for a credit card with a higher interest rate than someone who has not declared bankruptcy in the last 10 years (after 10 years, bankruptcy will no longer show up on a consumer’s credit report).
Under the federal risk-based pricing rule that became effective in 2011, if a financial institution gives you a loan or credit card with a higher interest rate than what it charges most consumers for the same product, it is supposed to give you an oral, written or electronic notice explaining that your account has been affected by risk-based pricing. The notice will explain what factors the creditor or lender used in determining the higher interest rate and how to get a free copy of your credit report.
Financial institutions also use risk-based pricing with existing customers. For example, if you miss the minimum monthly payment on your credit card, many issuers will increase your interest rate to the penalty APR based on your behaviour, which makes it look like you are at increased risk of not repaying what you owe.
Risk-based pricing is not the only factor that affects your interest rate, however. Your interest rate is also based on factors beyond your control, like the prime rate and overall economic conditions. Even the most creditworthy borrowers are likely to pay higher interest rates if the prime rate goes up or the economy goes into a recession.