Risk-based pricing
Risk-based pricing sets a loan’s interest rate according to the borrower’s credit risk, with each risk band priced to cover expected loss, funding cost, operating cost and target margin. Rate caps in some markets can limit how far pricing reaches into riskier bands.
Example
For illustration, a band with 4% funding cost, 3% annual expected loss, 2% operating cost and a 2% target margin would need a rate of roughly 11%. The calculation is 4% + 3% + 2% + 2%.
What goes into a risk-based price
A lender estimates annual expected loss for a band, then considers that alongside funding cost, operating cost and its target margin. The inputs need to be expressed on a compatible rate basis for the calculation to work.
The result is an estimated rate for that band, not a guarantee that the target margin will be achieved. The calculation depends on the lender’s estimates and the pricing limits that apply.
Risk bands, rate caps and lender notices
A lender groups applicants into risk bands based on its assessment of credit risk and sets its pricing policy. A rate cap in some markets can limit how far the rate for a riskier band can go.
If a rate is too high, better applicants in that band may leave. The remaining mix can have higher losses, a pattern known as adverse selection.
Some markets require notices related to risk-based pricing. In the US, a lender that prices on a credit report may need to send a risk-based pricing notice.
Questions we get asked
What if a rate cap is below the rate a band needs?
The cap can keep the rate below the level calculated for that band. The rate may then fall short of the lender’s target margin.
Does every applicant get a different rate?
No. A lender can set one rate for a risk band, so applicants in the same band may receive the same rate. Risk-based pricing does not mean a unique rate for every borrower.
Are risk-based pricing notices required in every case?
Not necessarily. In the US, a lender that prices on a credit report may need to send a risk-based pricing notice.
Decisimo’s free risk-based pricing calculator shows the rate each risk band needs for a target margin and which bands lose money at today’s rate.
