Risk-based pricing is a method that lenders use to determine interest rates and other loan and credit card terms based on the applicant's creditworthiness. Credit scores are the primary way lenders can evaluate your creditworthiness, but they may also consider other factors.
Read on to learn more about how risk-based pricing can affect your finances and what you can do to improve your creditworthiness.
How Risk-Based Pricing Affects Your Interest Rates
It's not uncommon to need a loan or line of credit to help finance a large purchase or cover your everyday expenses. Mortgages, auto loans, personal loans, and credit cards can all help you leverage your finances, but that privilege comes at a price.
While the majority of borrowers repay their debts, some don't. Banks and other lenders compensate for this risk by charging a range of interest rates on their loan and credit card products.
Depending on the type of loan or credit card, the interest rate range can vary. For example, the average credit card interest rate is 17.56% (as of November 2018), and the average interest rate on a new auto loan is 5.11% (as of the 4th quarter of 2017).
Regardless of the credit type, you can generally expect to score a below-average rate if you have an excellent credit history. If the lender views you as a risky borrower, you can expect to pay a higher interest rate.
Also, lenders have varying tolerances to risk. While some may be willing to lend to borrowers with less-than-stellar credit—at a higher interest rate, of course—others may deny your application outright.
As a result, it's important to not only know your credit scores but also what other factors lenders consider when reviewing your application.
How Lenders Determine Your Creditworthiness
Credit scores were designed to help lenders predict how likely you are to repay your loan or pay off your credit card. But your scores don't always show the full picture.
As a result, lenders often take a look at several aspects of your financial profile to assess whether you're a risk or not. The actual factors lenders consider and how they weight them can vary, but here are the general elements:
Credit Scores
Your credit score is a three-digit number that represents a snapshot of your credit report. It generally considers your:
- Payment history
- How much you owe
- Length of credit history
- New credit
- Credit mix
That said, you actually have several credit scores. Not only are there a handful of different credit scoring companies—FICO® and VantageScore are the main two—but each company can offer various models based on the type of credit you're applying for and improvements over time.
What's more, your credit scores can vary depending on which credit reporting agency the credit scoring model uses. Experian, Equifax, and TransUnion all gather and store data differently. Also, an error that shows up on your report with one agency may not show with the others.
As a result, you may see a different number when you check your credit score than what a lender sees when it checks. If the discrepancy is small, there's likely no need to worry. But if it's large, there may be an issue with one of your credit reports, and you should check for errors.
Debt-To-Income Ratio
You don't necessarily need to have a high income to get approved for a loan. But your debt-to-income ratio must be in a reasonable range.
Your debt-to-income ratio is calculated by dividing your total monthly debt payments by your monthly gross income. For instance, let's say you earn $60,000 per year and you have the following debt payments:
- Student loans: $300
- Auto loan: $350
- Mortgage: $1,300
- Credit card minimum payment: $50
Your total monthly debt obligation is $2,000, and your monthly gross income is $5,000, giving you a debt-to-income ratio of 40%.
The right debt-to-income ratio depends on the type of credit you're applying for. Double-check with the lender before you apply.
Other Credit Report Items
In addition to checking your credit score, a lender may also do a quick check of your credit reports to make sure there aren't any major red flags. Specifically, the lender will look at items such as:
- Delinquencies
- Collection and charged-off accounts
- Bankruptcies
- Foreclosures and short sales
- Recent credit inquiries
Tax liens and civil judgments used to be included in credit reports, but with recent regulatory changes, these items are no longer listed.
If you have any of these on your credit report, it can result in a higher interest rate or a denial. But over time, new positive information can help outweigh old negative information. Even then, it's wise to get caught up with payments and pay off any outstanding collections.
How to Improve Your Chances of Getting a Lower Interest Rate
Risk-based pricing protects lenders from losing money on their investments, but it's not ideal for consumers without a solid credit profile.
Even if you get approved, you could end up paying hundreds or even thousands of dollars more in interest over the life of your loan than if you scored a lower interest rate. So, it's important to know how to get a lower interest rate before you apply.
Get a Cosigner
If the lender you're applying with allows cosigners, consider asking someone with good credit and income to apply with you. This approach reduces the risk the lender takes on, which can result in a lower interest rate.
Just keep in mind that your cosigner is legally responsible for paying off the debt if you default, and the loan will show up on their credit report. If you fall behind on payments or stop making them entirely, it could damage your relationship.
Pay off Debt
Since your debt obligations are an essential factor in your credit score and lenders also consider your debt-to-income ratio, paying down debt can make a big difference.
If you have credit card debt, tackle that first. Lowering your balances can result in a fast uptick in your credit scores, and you'll also have the benefit of getting rid of high-interest debt. After that, focus on your other debts using either the debt snowball or debt avalanche method.
Understand the Lender's Eligibility Requirements
In some cases, you can avoid getting a high-interest rate offer just by knowing up front what credit profile the lender requires.
For example, most major credit card issuers charge high-interest rates on all of their rewards credit cards despite requiring good or excellent credit to get approved. But if you go to your local credit union, you may be able to get a lower rate without having perfect credit.
Also, while some personal loan companies prefer higher credit scores, others might be more willing to lend to you if you have poor or fair credit. Do your research before you apply to make sure you have the right lender.
What Happens If You Get Unfavorable Terms
If a lender gives you less favorable interest rates or other terms than other borrowers based on information it found in your credit report, it's required by law to provide you with one of the following notices:
- Risk-based pricing notice: Lenders provide this notice to a borrower after the terms of the loan or credit card have been set but before the borrower accepts them. Lenders can provide it in writing, electronically, or verbally.
- Credit score disclosure exception notice: This letter, which lenders can provide electronically or in writing, shares the borrower's credit score and the score distribution for the loan or credit card.
These notices may also share information about how to get a copy of your credit report, as well as your credit score and the negative factors affecting your credit score.
The Bottom Line
The best way to get a low-interest rate on your next loan or credit card is to improve your creditworthiness. Lenders consider credit scores, income, and debt, as well as other credit report items to determine how much interest to charge you.
If you don't get approved, you'll typically find out why when the lender sends you one of the required notices. This information can help you get your credit back on track.