Definition
Credit card companies and other lenders normally utilize risk-based pricing, in which various interest rates are charged to correspond with differing levels of risk among applicants. Applicants deemed to have higher risk are charged higher interest rates to compensate for higher probability of losses from the debt.
Analysis
Risk-based pricing is the tool that has allowed for expansion of credit markets to include those applicants that previously lacked substantial creditworthiness. Instead of denying credit to applicants with blemishes on their credit record, lenders have the option of charging more interest to offset the higher risk of default.
Prior to the 1990′s, a major segment of American consumers were ineligible for many unsecured credit products. Once credit card issuers embraced risk-based pricing, they found that borrowers with damaged credit were often the most profitable customers, even with the higher risk of default.
Risk-based pricing is what created the subprime mortgage market. Applicants with lower credit scores must pay higher interest rates to access credit.
Risk-based pricing is also responsible for payday lending. Interest rates on payday loans often exceed 400% APR.
