Risk Based Pricing

Quick Summary of Risk Based Pricing

A pricing methodology used by financial services companies to determine the interest rate and fees on loan products. The practice includes calculations that incorporate the borrower’s creditworthiness and the time value of money.

Risk-based pricing is the practice in the financial services industry to charge different interest rates on the same loan to different people, depending on their credit score and other factors which make it seem like they are more likely to not pay back the loan. Those with worse scores have a higher interest rate, those with better scores have a lower one. In most financial services companies and products, the credit score is by far the major element used to make this rate decision, income and assets are almost totally ignored (income, however, is used to decide if the loan is too high for the person to afford). The idea of the process is to avoid the tragedy of the commons, which happen if everyone had the same interest rate since those who were less likely to default are paying subsidizing in a way those who do default. In risk-based pricing, those who are more likely to default help pay for their own costs to the company, while those who have flawless records get supposedly cheaper interest rates than they could before.

This system has many critics. The main criticism is that it makes shopping around for interest rates much more difficult. This is because its almost impossible to tell at first glance if you will be qualified to get the lowest rate advertised. Depending on how it is implemented within the company, critics sometimes see the practice as a form of bait and switch. Other critics say that it is unfair in general because it creates a vicious cycle whereby the economically disenfranchised pay high-interest rates which can continue to keep them disenfranchised.

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