Risk Based Pricing in Consumer Lending

peer-to-peer-loans-disrupt-consumer-lendingHistorically, it would be difficult to secure a loan because of a bad credit history. However, things have improved vastly in the recent times. Credit providers created efficient tools to determine the risk for distinct consumers and price credit as appropriate. The data-driven risk-based pricing methodology has been to a large extent responsible for providing credit to several consumers.

Risk-based pricing in consumer finance customizes the price and terms of a loan to a borrower’s capability to repay, enabling lenders to provide credit to many consumers. All creditors have to overcome a risk spectrum of probable borrowers. Distinct borrowers have a specific uniqueness that determines the possibility of default on a loan.

Borrowers with high risk are very costly for lenders to serve in comparison to lower-risk borrowers. Risk-based pricing looks at connecting the price a borrower pays for the cost incurred by the lender by adapting the price of the loan to distinct borrower’s possibility of default.

In the last two decades, consumer lenders have depended on statistical credit scoring models to forecast a borrower’s default risk and establish loan interest rates relevant for the risk. The significant expansion of credit to consumers in the US in the last three decades developed concurrently with the large scale adoption of risk-based pricing by bank credit card providers.

By customizing pricing to distinct borrowers, a specific creditor can efficiently vie for low-risk customers, while extending credit to higher-risk borrowers at higher prices. In comparison with the single price that caters to all practices, risk-based pricing reduces the cost of credit for most of the borrowers, but also extends credit availability to higher-risk borrowers and results in a wider range of loan products being available across income groups.

The major credit decision at present is on the basis of specific data pertaining to a borrower’s previous payment history and existing obligations. The utilization of credit scoring and risk-based pricing has drastically enhanced the stability of a creditor’s lending outcomes.

Credit scoring and risk-based pricing facilitated a huge growth in credit opportunities for consumers across the socioeconomic range. One of the positive features of credit scoring as a decision-making tool is that data enhances the capability of the models to revamp a lender’s evaluation and pricing or risk.

Several consumers have accessed credit to finance their consumption requirements. Small businesses utilize credit to finance the purchase of equipment/materials.

Restrictions such as regulation would limit the utilization of credit report information or the multiple scoring and pricing tools that have been constructed with the data. In other words, without top-notch risk-based pricing, several higher-risk consumers would not have access to traditional loans.

All loans have a distinct feature. Each consists of transactions wherein the lender delivers funds based on the expectation that the borrower would pay back in the future. However, lenders are often not sure about the risk related to a particular applicant. Credit reporting assisted in decreasing the costs.

Credit scoring enabled lenders to use the data in credit reports effectively. Risk-based pricing has transformed the loan sector from a single price fits all model and extended credit and options across various segments. Most of the credit decisions at present are on the basis of accurate data pertaining to a borrower’s previous payment history and existing constraints.

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