Assume that your brother asks you $ 5.000 to buy a new machine for his small business. You know him pretty well, you know his credit history and you believe that his business is doing well so far.
Suppose now that it is not your brother anymore, but a friend from college. You have not seen him in a while but you know he works hard, he got a job from the past 5 years with good promotions and he always lived in the same city.
What about a co-worker who just moved 5 months ago to work with you? As the social distance gets longer, you have less and less confidence about the repayment.
Now, take a step further, and imagine that you live in California. A guy from New York asks you $ 2.000 loan to cover a quick debt and he will pay you back in 3 months. How do you know if you can trust him?
You don’t! That’s the challenge credit institutions deals with every day.
Some time ago, financial institutions relied on loan officers’ judgment to set a one-size-fits-all price, as well as individuals’ credit status.
Nevertheless, in 2011 the federal risk-based pricing rule became effective. Now, institutions and borrowers have a fair, financial inclusive and innovative pricing model.
In today’s post, we will cover how risk-based pricing model affects your APR and how to negotiate it. Them, we will explain when this model is a good option, when it is unfair and a list of companies that offers risk-based pricing deals.
On the fixed-pricing model, the creditor fixes the same price for good and bad score individuals. But, the Risk-based pricing model sets the prices and loan terms according to the borrowers’ risk.
The borrowers’ risk level is determined not only by the Credit Score but also from other drivers, such as:
- Employment status and history.
- Adverse credit history.
- Loan-to-value ratios.
- Debt-to-income ratios.
- Loan amount and purpose.
- Asset amounts.
- Secured or unsecured loans.
These factors might change between lenders. Some of them consider how long you’ve lived in your home, because if you are changing places frequently, you may be in a risk range.
They also evaluate external factors, such as the prime rate and the country’s economy (unemployment, fiscal policy, exchange rates, productivity, etc).
The risk-based pricing model relates to the Default Probability. Which represents the chance of not getting the repayments back to the lender.
The creditor considers all the drivers (cited above) that might affect the probability of default from the borrower. The higher the default probability, the higher your APR may be.
How to negotiate your APR on a risk-based pricing model?
The fact that risk-based pricing model uses other factors besides Credit Score may give you a wider range of negotiation about your APR.
Here are some tips to help you at the negotiation phase. Always make sure to be honest and ethical.
- Understand all the nuances of why this is your price.
Take your time to talk with the creditor so they can explain deeply why this is your price. Maybe you have facts on your history that were not exposed that might help you lower your risk.
For example, if you moved between places recently, and they consider that a risk factor, you can say that you work remotely (if that is the case). So your moving did not affect your income status.
- Check the creditor’s APR math.
To calculate the APR is not that complicated. Always make sure to ask your creditor the details on how did they got to that number.
You may even calculate it yourself or use a spreadsheet and compare to see if the results match.
- Compare loans between different lenders.
When considering a loan, there is no reason to get yourself attached to one option.
Always compare different creditors APR, and if possible, let the competitor know that you are getting better offers.
- Consider your collateral requirement.
An unsecured loan will get a higher APR compared to secured loans. Therefore, if you decide to include an asset as a collateral requirement you might get lower APRs.
You also have to analyze the nature of the asset itself. For example, if you set your car as a collateral requirement, you will get higher APR compared to your home.
When is Risk-Based Pricing model a good option (or not)?
To choose the correct model depends on your current situation. The risk-based pricing model is a valuable choice if you have a good reputation with good credit history. That way, you will get reduced prices and good products.
However, if you present red flags on your financial situation, you will end up paying higher rates, and not getting an affordable deal.
When is Risk-based pricing unfair?
Despite the high flexibility, there is a fine line between a fair to an unfair pricing.
- Inadequate risk assessment.
If you have a bad credit score, that is a direct factor of high risk. But, if the lender argues that your income comes from a fluctuated market, you should get on the details about where this conclusion came from.
Always seek for accuracy from the lenders’ assessments.
- Nondisclosure of rates.
Usually the funding institution will give you a hard time on your market research. They do that by not giving you full disclosure about the interest rates, especially not in the starting process.
This will cost you a lot of time and effort, making you more coercive on signing for higher rates.
- Predatory funding.
The crisis in 2007 was a clear example of predatory funding through sub-prime rates. The initial rates may be small but the lenders do not expose the limits of the rates.
After some time, they boost the rates up, driving payments up and generating default on the loans increasing your debt.
- Discrimination of needy borrowers.
Low-risk borrowers pay for the lower rates and best products, high-risk borrowers get the higher rates and worst products.
Usually, high-risk individuals fall into a deep cycle of debt. They only have access to expensive lending, and most of the time, they do not have enough income to pay the debt.
Risk-based pricing may provide you flexible terms for a loan. Whenever you consider borrowing, make sure to ask the creditor what factors are behind your APR. Even if you have a bad credit score, it does not necessarily means that you will get a terrible deal. However, you have to bring up relevance to others low risk factors and history. Are you considering getting a loan or recently experienced unfairness in your evaluation? Share your thoughts and feel free to contact us if you have any questions.