Risk-based pricing
From Wikinvestor
Risk-based pricing is a methodology adopted by many lenders in the mortgage and financial services industries. It has been in use for many years as lenders try to measure loan risk in terms of interest rates and other fees. The interest rate on a loan is determined not only by the time value of money, but also by the lender's estimate of the probability that the borrower will default on the loan[1]. A borrower who the lender thinks is less likely to default will be offered a better (lower) interest rate. This means that different borrowers will pay different rates.
The lender may consider a variety of factors in assessing the probability of default. These factors might be characteristics of the individual borrower, like the borrower's credit score or employment status. These factors might also be characteristics of the loan; for example, a mortgage lender might offer different rates to the same borrower, depending on whether that borrower wished to buy a single-family house or a condominium.
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Property types
Pertaining to residential mortgages and their risk based pricing methods, the Property Type is sub-categorized as follows:
- Single Family Residence (SFR)
- Multi-Family 2-4 Units (MF)
- Townhome/Condominium (TC)
SFRs are considered to have the highest dollar value per square foot and are thus the most favorably priced of the property types in the eyes of the lending institution. The property is stand alone, or 'detached' from other property.
Multi-family and townhome/condominiums are typically 'negatively priced', where the lender will assess a .5% to .75% increase in the actual interest rate or the price of an interest rate, due to their relative lower dollar per square foot values.
Criticism
The main criticism among mainstream consumers has been that risk-based pricing can make 'shopping' for the best interest rates much more difficult. It is almost impossible to tell at first glance if one can be qualified to get an advertised rate or exactly what interest rate they qualify for at all. Consumer-rights advocates also believe that risk-based pricing in the extreme, especially in the form of predatory lending, hurts financially disadvantaged and vulnerable consumers by cutting them off from reasonably affordable capital and exposing them unwittingly to soaring interest rates and unsustainable financing schemes that erode equity and may lead to default. Risk-based pricing can be manipulated to wield deceptive marketing practices, such as the bait and switch. The fairness of similar lending practices within the mortgage industry is being investigated by Congress.
