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.
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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.
