Risk-based pricing
Encyclopedia
Risk-based pricing is a methodology adopted by many lenders in the mortgage
and financial services
industries. It has been in use for many years as lenders try to measure loan risk in terms of interest rates and other fees. The interest rate on a loan is determined not only by the time value of money
, but also by the lender's estimate of the probability that the borrower will default on the loan. A borrower who the lender thinks is less likely to default will be offered a better (lower) interest rate. This means that different borrowers will pay different rates.
The lender may consider a variety of factors in assessing the probability of default. These factors might be characteristics of the individual borrower, like the borrower's credit score
or employment status. These factors might also be characteristics of the loan; for example, a mortgage lender might offer different rates to the same borrower, depending on whether that borrower wished to buy a single-family house
or a condominium
.
and history, property use
, property type, loan amount, loan purpose
, income, and asset amounts, as well as documentation levels, property location, and others, are common risk based factors currently used. Lenders 'price' loans according to these individual factors and their multiple derivatives. Each derivative either positively or negatively affects the cost of an interest rate. For example, lower credit scores equal higher interest rates and vice-versa; typically, those who provide less verifiable income documentation due to self-employment benefits will qualify for a higher interest rate than someone who fully documents all reported income. Mortgage and other financial service industries value credit score and history most when pricing mortgage interest rates.
SFRs are considered to have the highest dollar value per square foot and are thus the most favorably priced of the property types in the eyes of the lending institution. The property is stand alone, or 'detached' from other property.
Multi-family and townhome/condominiums are typically 'negatively priced', where the lender will assess a .5% to .75% increase in the actual interest rate or the price of an interest rate, due to their relative lower dollar per square foot values.
, hurts financially disadvantaged and vulnerable consumers by cutting them off from reasonably affordable capital and exposing them unwittingly to soaring interest rates and unsustainable financing schemes that erode equity and may lead to default. Risk-based pricing can be manipulated to wield deceptive marketing practices, such as the bait and switch
. The fairness of similar lending practices within the mortgage industry is being investigated by the United States Congress.
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
and financial services
Financial services
Financial services refer to services provided by the finance industry. The finance industry encompasses a broad range of organizations that deal with the management of money. Among these organizations are credit unions, banks, credit card companies, insurance companies, consumer finance companies,...
industries. It has been in use for many years as lenders try to measure loan risk in terms of interest rates and other fees. The interest rate on a loan is determined not only by the time value of money
Time value of money
The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory....
, but also by the lender's estimate of the probability that the borrower will default on the loan. A borrower who the lender thinks is less likely to default will be offered a better (lower) interest rate. This means that different borrowers will pay different rates.
The lender may consider a variety of factors in assessing the probability of default. These factors might be characteristics of the individual borrower, like the borrower's credit score
Credit score
A credit score is a numerical expression based on a statistical analysis of a person's credit files, to represent the creditworthiness of that person...
or employment status. These factors might also be characteristics of the loan; for example, a mortgage lender might offer different rates to the same borrower, depending on whether that borrower wished to buy a single-family house
House
A house is a building or structure that has the ability to be occupied for dwelling by human beings or other creatures. The term house includes many kinds of different dwellings ranging from rudimentary huts of nomadic tribes to free standing individual structures...
or a condominium
Condominium
A condominium, or condo, is the form of housing tenure and other real property where a specified part of a piece of real estate is individually owned while use of and access to common facilities in the piece such as hallways, heating system, elevators, exterior areas is executed under legal rights...
.
Risk factors
Credit scoreCredit score
A credit score is a numerical expression based on a statistical analysis of a person's credit files, to represent the creditworthiness of that person...
and history, property use
Property Use
Property UsePertaining to residential mortgages and their risk-based pricing methods, the property use is sub-categorized as follows:A second home is viewed and priced according to lender, some will asses the same risk factor as a primary residence while others will factor in a 0.125% to 0.5%...
, property type, loan amount, loan purpose
Loan Purpose
Pertaining to mortgages and their risk based pricing factors, the loan purpose factor is sub-categorized by purchase, Rate & term refinance and cash-out refinance....
, income, and asset amounts, as well as documentation levels, property location, and others, are common risk based factors currently used. Lenders 'price' loans according to these individual factors and their multiple derivatives. Each derivative either positively or negatively affects the cost of an interest rate. For example, lower credit scores equal higher interest rates and vice-versa; typically, those who provide less verifiable income documentation due to self-employment benefits will qualify for a higher interest rate than someone who fully documents all reported income. Mortgage and other financial service industries value credit score and history most when pricing mortgage interest rates.
Property types
Pertaining to residential mortgages and their risk based pricing methods, the Property Type is sub-categorized as follows:- Single Family Residence (SFR)
- Multi-Family 2-4 Units (MF)
- Townhome/Condominium (TC)
SFRs are considered to have the highest dollar value per square foot and are thus the most favorably priced of the property types in the eyes of the lending institution. The property is stand alone, or 'detached' from other property.
Multi-family and townhome/condominiums are typically 'negatively priced', where the lender will assess a .5% to .75% increase in the actual interest rate or the price of an interest rate, due to their relative lower dollar per square foot values.
Criticism
The main criticism among mainstream consumers has been that risk-based pricing can make 'shopping' for the best interest rates much more difficult. It is almost impossible to tell at first glance if one can be qualified to get an advertised rate or exactly what interest rate they qualify for at all. Consumer-rights advocates also believe that risk-based pricing in the extreme, especially in the form of predatory lendingPredatory lending
Predatory lending describes unfair, deceptive, or fraudulent practices of some lenders during the loan origination process. While there are no legal definitions in the United States for predatory lending, an audit report on predatory lending from the office of inspector general of the FDIC broadly...
, hurts financially disadvantaged and vulnerable consumers by cutting them off from reasonably affordable capital and exposing them unwittingly to soaring interest rates and unsustainable financing schemes that erode equity and may lead to default. Risk-based pricing can be manipulated to wield deceptive marketing practices, such as the bait and switch
Bait and switch
Bait-and-switch is a form of fraud, most commonly used in retail sales but also applicable to other contexts. First, customers are "baited" by advertising for a product or service at a low price; second, the customers discover that the advertised good is not available and are "switched" to a...
. The fairness of similar lending practices within the mortgage industry is being investigated by the United States Congress.