In many commercials or ads for loans, you may hear something like “rates subject to credit approval” or “upon credit approval”. But what does that actually mean for you?
Risk-based lending occurs when lenders offer consumers different interest rates or other loan terms, based on the estimated risk that the consumers will fail to pay back their loans. Typically, banks and credit unions determine loan interest rates using more than just your credit score. While credit scores are an important tool to estimate credit risk, they are not the sole determinant of whether or not you will get approved for a loan or will face a lower interest rate. Instead, there are a number of factors that can come into play.
What Determines Risk-Based Pricing
At most credit unions, when you apply for a loan, the credit union will pull your credit report. This report contains your credit score as well as your monthly debt such as other loans you are paying on and any collections you may have. Using this credit report, and information you provide in your loan application, credit unions can use your total income and total debt to calculate your debt to income ratio. For many credit unions, there is a certain ratio that when exceeded, can require extra approval for an individual loan to be accepted. Most financial institutions recommend a debt to income ratio of less than 35%.
Credit unions often also look at the type of credit lines that you have open. A secured trade line means something is being held as collateral in place of the loan. Unsecured trade lines are things such as credit cards, student loans and lines of credit. When looking at the unsecured lines, credit unions often look at the credit limit and what is owed, which gives information about how much capacity an individual has to borrow.
However, there are certain legally prohibited factors to decide whether to give you a loan or how much to charge you. These mostly include demographic information, such as age, race, religion, national origin, sex, and marital status.
Pros and Cons of Risk-Based Lending
Risk-based pricing gives people an opportunity they otherwise would not have had. Instead of being denied a loan or credit card, they’re given the chance to borrow at a higher price. If these individuals are presented with information that helps them understand this pricing system, then the system can be beneficial to everyone involved. Recently, there have been regulation efforts to make this practice much more transparent. Additionally, borrowers with higher interest rates, may be able to refinance their debt to a lower rate once their credit score increase; meaning they don’t need to be stuck with a higher rate for the life of the loan.
Unfortunately, not all lenders are member-focused or not-for-profits, like credit unions. Under a risk-based pricing model, some lenders may charge borrowers with less favorable credit scores extremely high rates. Some borrowers may not know that they have bad credit, and that the rates they are being charged are significantly higher than someone with higher credit score.
Tips to Get the Best Deal
- Maximize your credit score (Contact GreenPath Financial Wellness for free credit counseling).
- Keep your debt-to-income ratio low (below 35% if possible).
- Compare rates with multiple lenders to ensure you are getting fair rates.
- Be aware of all terms of a loan, including any tiered-pricing conditions.
- Use sites like bankrate.com to research range of interest rates being charged for loans and credit cards.
