How Do Risk-Based Pricing Affects Your APR

ElitePersonalFinance
Last Update: February 15, 2021 Credit Report Loans

Lest say 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 believe that his business is doing well so far.

Suppose now that it is not your brother anymore, but a college friend. 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 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, financially inclusive, and innovative pricing model.

We will cover how the risk-based pricing model affects your APR and how to negotiate it in today’s post. 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.

Risk-Based Pricing

The creditor fixes the same price for good and bad score individuals on the fixed-pricing model. 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.
  • Income.
  • 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.).

Default Probability

The risk-based pricing model is related to the Default Probability. This represents the chance of not getting the repayments back to the lender.

The creditor considers all the drivers (cited above) to affect the borrower’s probability of default. The higher the default probability, the higher your APR may be.

How to Discuss Your APR on a Risk-Based Pricing Model?

The fact that the 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 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 consider that a risk factor, you can say that you work remotely (if that is the case). So your move did not affect your income status.

  • Check the creditor’s APR math

To calculate the APR is not that complicated. Make sure to ask your creditor how they got to that number.

You may even calculate it yourself or use a spreadsheet and compare it to see if the results match.

  • Compare loans between different lenders

There is no reason to get yourself attached to one option when considering a loan.

Always compare different creditors’ APRs, 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 collateral, 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 a higher APR than your home.

When is the 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 pay higher rates and not get an affordable deal.

When is Risk-Based Pricing Unfair?

Despite the high flexibility, there is a fine line between fair and 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 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 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 rates’ limits.

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 the lower rates and best products. High-risk borrowers get 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.

Conclusion

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 mean that you will get a terrible deal. However, you have to bring up relevance to other 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.

MEET THE AUTHOR

ElitePersonalFinance


Recommended Articles

Debt

Best Direct Lenders 2021

EPF July 4, 2021
Debt

Can I Get 0 Interest Personal Loan?

EPF May 25, 2021

AS SEEN ON