Date:6 April 2011 I Comments: 0 I Views:8,035

In a nutshell risk based pricing is the reason why people with a poor credit score pay higher interest rates for credit.

It is standard practice to charge a higher rate of interest to a customer who is considered ‘higher risk’.

The price is based on the perceived risk involved in lending money to someone who might not have a very good track record with credit.

I’m struggling to come up with a really good argument for why this is a good idea…

People with either a history of badly managed credit or with no provable track record of managing credit could quite easily be considered higher risk than a person with exceptional credit management skills but why do they pay more for credit? How does that lower the amount of risk to the lender?

Risk based pricing combined with relaxed lending led to people with poor credit being given loans and mortgages at over the top rates. This led to missed payments, defaults, repossessions and a small hiccup in the global supply of credit.

I see that as a huge flaw with risk based pricing.

Now mortgage lenders in the UK are looking much more at affordability when it comes to borrowing in an attempt to control the amount of risk they are exposed to. Income multiples are only a guide these days and some lenders only let you borrow at a low rate if you can prove you can afford a mortgage at a higher rate. Other lenders insist on a certain amount of disposable income after essential expenses are paid.

This is a more responsible way to lend but these are the rules that apply to people with good credit!

At the moment, people with poor credit are still struggling to borrow money.

Money lenders are still trying to avoid risk.

In the past the theory was the reward should reflect the risk…

That makes sense if you’re talking about the adrenaline rush from jumping out of a plane.

However this school of thinking traditionally applies to investing which, also makes sense when taking a gamble on the future success of a business based on the business plan, market conditions and potential for growth.

When money that gets invested in financial institutions it ends up as credit and to reflect the risk of lending to poor credit customers and improve the reward the investor is offered a higher rate of return and the borrower is charged a higher rate of interest.

Who would invest in a business if the business plan was to lend money to high risk customers?

See link:  > Collateralized Debt Obligation <

Risk based pricing failed and it should not be used to entice hungry investors into high returns at the expense of others.

Basing lending on affordability and credit history is a more responsible approach.

People with poor credit should pay the same rate as everybody else (or if it’s increased the margin should have a maximum and reasonable threshold) but the amount they can borrow should be restricted.

A borrower with a poor credit history wishing to buy a house would need a bigger deposit as an incentive to save and manage money and to ensure they have a quantifiable interest in the property they are buying.

Credit card issuers can help people with poor credit by only extending small balances and really highlighting the fact that cards are only for short term borrowing and if credit is paid back quickly there is no interest to pay.

Some people will still max out their cards but if their credit limit is low the risk to the lender is low.

Borrowers need to be educated before they themselves take a risk and enter into a credit agreement.

After years of slack regulation and easy money the public’s perception of credit needed to change and that has happened to some extent but lenders should understand it was not the public that was at fault in the past and with a more sensible and responsible approach to lending the adverse credit market could be opened back up and actually help repair the damage caused and overcome the stigma attached to past practices.

Category: Debt