Risk-based pricing
From Wikipedia, the free encyclopedia
Risk-based pricing is the methodology within the mortgage and financial service industries to cost prequalified programs and subsequently adjust interest rates, mitigating any increased risk with increased cost. Risk factors generally depend on an individual's financial and credit risk factors, as well as the perceived risk of underlying property or other collateral.
[edit] Risk factors
Credit score and history, Property Use, Property Type, Loan Amount, Loan Purpose, income, and asset amounts, as well as documentation levels, property location, and others, are common risk based factors currently used. Lenders 'price' loans according to these individual factors and their multiple derivatives. Each derivative either positively or negatively affects the cost of an interest rate. For example, lower credit scores equal higher interest rates and vice-versa; typically, those who provide less verifiable income documentation due to self-employment benefits will qualify for a higher interest rate than a someone who fully documents all reported income. Mortgage and other financial service industries value credit score and history most when pricing mortgage interest rates.
[edit] 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.
[edit] Criticism
The main criticism of the methodology is that it can make 'shopping' for 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. Risk-based pricing can also be manipulated within a business practice to wield deceptive marketing and predatory lending practices such as the bait and switch.
