Everything You Should Know About Risk-Based Pricing
Risk-based pricing is a method lenders use to determine your interest rates and loan terms by examining your credit report.
Written by Macy Fouse
Reviewed by Jessica Barrett
Table of Contents
- Why it's used
- How it works
- Determining creditworthiness
- Getting a lower interest rate
- Finding car insurance
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Risk-based pricing is a method lenders use to determine your interest rates (or other loan terms) based on your creditworthiness. Your creditworthiness is determined mainly by your credit score, but companies consider other factors as well.
Risk-based pricing sounds intimidating—that’s why
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Why do companies use risk-based pricing?
Between mortgages, car financing, education, credit cards, or other big purchases, the majority of people will need a loan or line of credit at some point in their lives. Most people repay their loans according to the agreement they signed—but some borrowers don’t. This means the lenders could lose a lot of money.
To mitigate this risk, banks and other lenders charge interest on loans and credit cards. Interest rates can vary by company and loan type, of course, but they can also depend on the borrower’s financial history and creditworthiness.
The risk-based pricing model adds a layer of security for lenders when lending to people who seem less likely to make their payments. These high-risk borrowers will be charged higher interest rates, while low-risk borrowers—who seem likely and able to make payments—will be charged lower interest rates.
MORE: How to calculate total interest paid on a car loan
How does risk-based pricing work?
When you apply for a loan or line of credit, lenders assess your risk and determine your creditworthiness. This largely depends on your credit score, but different lenders appraise different factors. Once the lender ascertains your creditworthiness, they decide on your loan terms—including your interest rates.
If a company or financial institution offers you loan terms with a higher interest rate than most consumers, they are required by law to provide you with a risk-based pricing notice before you accept the offer. This notice can be delivered orally, electronically, or on paper.
A risk-based pricing notice will include the notice itself, as well as all of the factors that were used to determine the higher interest rates. This rule was created to prevent any unfairness in the credit market and to avoid any predatory lending.
Key Takeaway: The interest rates you’re offered by lenders depend almost entirely on your credit report.
How do lenders determine creditworthiness?
Lenders offer loan terms and interest rates based primarily on credit profile characteristics, but some companies use additional sources. Here are the most frequently-used factors in determining your creditworthiness.
Credit scores
Your credit score is a number representing your financial history. This includes your payment history, the debts you owe, the length of your credit history, any new lines of credit, and the types of credit or loan accounts you have (i.e. your credit mix).
There are a few different credit scores, like FICO and VantageScore, but FICO is the preferred choice of most lenders.
Your credit score can also vary depending on which credit reporting agency you use because they gather data differently. One may show an error while others don’t, so be sure to check more than one credit report to get an accurate idea of your score.
Debt-to-income ratio
Your debt-to-income ratio is the range lenders use to determine your creditworthiness. This is measured by dividing your monthly debt payments by your gross monthly income. The best ratio depends on your lender and what type of loan or credit you need.
Credit report items
To be thorough, lenders may examine additional items from your credit reports other than just your credit score. These items can include the following:
- Delinquencies. Credit card or other loan payments more than one month late are considered delinquent. Delinquencies aren’t typically reported to credit reporting agencies until two or more payments are missed.
- Collection accounts. Paid or unpaid collection accounts can stay on your credit report for up to seven years after the account became delinquent. New additions can affect your credit score significantly, but the impact of these debts on your score will diminish over time.
- Bankruptcies. After filing for bankruptcy, the record stays on your credit report anywhere from seven to 10 years.
- Foreclosures. If you fall behind on your mortgage for 120 days and have to go through the foreclosure process, it will definitely drop your credit score. Foreclosures and short sales stay on your credit report for seven years.
- Recent credit inquiries. Depending on the type of credit inquiry, it may show up on your credit report and even lower your score. Soft inquiries—i.e. checking your own credit report—don’t affect your score. Hard inquiries made by lenders or financial institutions temporarily drop your score by several points.
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How can I get a lower interest rate?
If you have a less-than-stellar credit profile, you could be paying thousands more in interest rates. That’s why it’s crucial to know how to increase your creditworthiness before you apply.
If you get stuck with less-than-ideal loan terms or interest rates, the process to reduce your rates is much more complicated. Here are some of the most effective ways to improve your credit profile.
Pay off your debt
Since a huge part of your credit score is comprised of your debt commitments, paying them off can make a considerable difference. Paying off debts would also improve your debt-to-income ratio, boosting your creditworthiness to lenders.
The most important debt to address is credit card debt since the interest rates on credit cards tend to be higher than loan debts. Without this debt weighing down your score, your number is sure to increase.
Find a cosigner
Lenders will view you as less of a risk if you have a cosigner with good credit and income. Having a cosigner will likely earn you a lower interest rate.
A downside to having a cosigner, though, is that they are legally accountable for the debt if you fail to make payments. If this happens, the loan will affect their credit report, too—not just yours. Not only could this damage your relationship, but could also devastate their credit score and finances.
Research your lender
Save yourself some trouble by doing your due diligence before applying for a loan or credit. If you know what your lender is looking for specifically, you could dodge those high-interest-rate offers altogether.
For instance, some credit card companies have high-interest rates across the board for certain credit cards, no matter how good your credit score is. But you could avoid high rates by going to your local credit union instead, as they tend to be less strict about credit scores.
While some lenders may have rigid requirements, others may be more relaxed and willing to lend to borrowers with lower credit scores. It’s always worth checking into your lender before applying.
Key Takeaway: Paying off debts, getting a cosigner, and researching your lender’s requirements can help you avoid high-interest rates, even if you have bad credit.
MORE: The best car insurance for bad credit drivers
How do I find car insurance for my financed vehicle?
Most car insurance companies also use a form of risk-based pricing when deciding your rates. The premiums you’re offered depend on a number of factors—including your age, driving record, and vehicle.
Regardless of your creditworthiness or risk level,
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