Risk Based Pricing – A Helpful Explanation to Better Understand It
The idea of risk based pricing is when the lender determines the interest rate for a loan based upon the risk of the person defaulting on the loan. This is determined by the person’s credit rating. The person who is less likely to not pay back the loan will get a lower interest rate and have to pay less back to the bank in the long run. There are other factors that the lender takes into account when determining the interest rate in risk based pricing. They will also consider the person’s status of employment and possibly even the type of loan being requested.
The risk factors when determining risk based pricing are as follows:
- Credit rating – How good your credit score is helps to determine the probability that you will pay back any money that is extended to you in a loan or as credit.
- Loan amount – Usually, the more money you request in a loan, the higher your interest will be if you are determined to be at a higher risk for paying the money back.
- Loan type – Generally, home loans have higher interest rates than automobile, motorcycle or boat loans do. Again, it goes back to how much money is being requested in the loan.
- Type of property (if it’s a mortgage loan) – A private home will sometimes have higher interest than a business. The reason for this is because, again, the amount of funds being requested is generally less – unless you are buying a business building and everything in the business.
All of these things can have a tremendous impact on whether or not you are considered to be at a high risk for loan pricing and will affect your interest rate on the loan. The better off you are financially and the better you are at paying your bills, the better your chances are of not having a high interest rate on your loan.
The main concern about risk based pricing is that it makes it more difficult to find a better interest rate. If one lender determines you are at high risk, then others are likely to do the same. It is difficult to know if you can get a low interest rate based on this type of pricing because you do not know how you will measure up to their rating criteria. Even so, others argue that this is a good way to lend money as it enables the bank to get a return on a risky investment.