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What is Risk-Based Pricing?

Risk based-pricing is considered by many to be the future of lending and is becoming more and more prevalent in this new wave of neo banks and neo lenders.

Risk-based pricing in the credit market refers to the offering of different interest rates and loan terms to different consumers based on their creditworthiness. The rate is usually determined by way of a credit score or algorithmic assessment.

Lenders can modify their risk-based pricing procedures to consider unique circumstances for credit scores, debt to income ratios, loan to value ratios and other key data points in their lending decision processes. These data points can vary from lender to lender, as some lenders could have vastly different qualification guidelines to others. Risk-based pricing can help to clarify the types of risk and circumstances that each lender is willing to accommodate.

Risk-based pricing allows lenders to use a borrower’s credit profile to charge an interest rate that is tailored with consideration to the risk profile of the loan. This means that a similar loan product will not always mean the same loan terms and interest rate. A higher risk borrower that is deemed to be less likely to abide by the terms of their loan will be charged a higher interest rate, while a lower risk borrower deemed to be more likely to follow the terms of the loan is rewarded with a lower interest rate.

When the creditworthiness of a borrower is established, a loan solution is then tailored to them, with an interest rate that caters for the borrower’s unique circumstances. Using Risk-Based Pricing, a lender can calculate the rate and repayments of a loan based on the likelihood of default by the borrower. This allows the lender to offer the best market rate for any given circumstance.

The traditional lending process will assess loan applications based on a credit policy for a predetermined product and its associated pricing.   In this model two very different borrowers of different credit quality may qualify for the same interest rate and product. This can result in different profitability outcomes for the lender, based on the cost of servicing each loan.  For example, if a borrower has a history of making payments on time and not falling into arrears, this lowers the associated cost of servicing a loan, such as the requirement to frequently chase payments from the borrower.

Australian Mortgage Marketplace is doing things differently. Our Intelligent Credit app uses risk-based pricing and considers over 100 data points to provide a credit score between 1-1000, with a lower score being a lower risk of impairment. These data points include:

  • Loan to Value Ratio
  • Credit history
  • Income and expenses
  • Loan type e.g. owner occupied or investment
  • Loan term
  • Loan features e.g. offset or interest only
  • Borrower type e.g. First Home Buyer
  • Security type e.g. low-density home, regional, high rise

Risk-based pricing delivers a more consistent and accurate pricing approach, providing more margin certainty to lenders, and is generally regarded as a fairer approach by providing better terms to the more creditworthy borrowers.

Risk-based pricing has seen rapid growth in the United States.  Of particular note is the retail lender, Quicken Loans. Quicken Loans is an online mortgage lender based out of Detroit, Michigan, and last year became the United States largest retail lender, outperforming the 150 year old institution Wells Fargo.  Last year Quicken Loans settled $100 Billion in loans, enabled by their Rocket Mortgage product, where an application can usually be completed entirely on a mobile device and generate an offer of loan terms and (risk-based) pricing within minutes.

If you’d like to learn more about how Australian Mortgage Marketplace will be using our Intelligent Credit technology, please watch the short video below.