Credit-scoring systems and risk-based pricing & Other risk-based pricing factors

Credit-scoring systems:     

Because a loan’s risk varies according to its characteristics and its borrower, the assignment of a risk or default premium is one of the most problematic aspects of loan pricing.


A wide variety of risk-adjustment methods are currently in use. Credit-scoring systems, which were first developed more than 50 years ago, are sophisticated computer programs used to evaluate potential borrowers and to underwrite all forms of consumer credit, including credit cards, installment loans, residential mortgages, home equity loans and even small business lines of credit. These programs can be developed in-house or purchased from vendors.


Credit scoring is a useful tool in setting an appropriate default premium when determining the rate of interest charged to a potential borrower. Setting this default premium and finding optimal rates and cutoff points results in what is commonly referred to as risk-based pricing. Banks that use risk-based pricing can offer competitive prices on the best loans across all borrower groups and reject or price at a premium those loans that represent the highest risks.


So, how do credit-scoring models and risk-based pricing benefit the borrower who only wants a loan with reasonable repayment terms and an appropriate interest rate charge? Since a bank is determining a reasonable default premium based on past credit history, borrowers with good credit histories are rewarded for their responsible financial behavior. Using risk-based pricing, the borrower with better credit will get a reduced price on a loan as a reflection of the expected lower losses the bank will incur. As a result, less risky borrowers do not subsidize the cost of credit for more risky borrowers.


Other risk-based pricing factors :

Two other factors also affect the risk premium charged by a bank: the collateral required and the term, or length, of the loan. Generally, when a loan is secured by collateral, the risk of default by the borrower decreases. For example, a loan secured by a car typically has a lower interest rate than an unsecured loan, such as credit card debt. Also, the more valuable the collateral, the lower the risk. So it follows that a loan secured by the borrower’s home typically has a lower interest rate than a loan secured by a car.


However, there may be other factors to consider. First, the car may be easier to sell, or more liquid, making the risk of the loan lower. Second, the term, or length of a car loan is usually short—three to five years—as compared to the 15- to 30-year term of a home loan. As a general rule, the shorter the term, the lower the risk, since the ability of the borrower to repay the loan is less likely to change.


Assessing the interplay of credit score, collateral and term to determine the risk premium is one of a lender’s most challenging tasks. Whether loan-pricing models are based on a simple cost-plus approach or price leadership, use credit-scoring or other risk-based factors, they are valuable tools that allow financial institutions to offer interest rates in a consistent manner. Knowledge of these models can benefit customers as well as banks. Although it cannot help customers make their payments, an awareness of loan-pricing processes can ease the uncertainty that may be involved in applying for a loan.

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