Ebook Risk-based Pricing of Interest Rates in Household Loan Markets
The credit industry literature suggests that by the early 1980s conventional lenders were using credit scores and the like to automate underwriting standards, but as late as the early 1990s they simply posted one “house rate” for each loan type and rejected most high-risk borrowers (Johnson, (1992)). As data storage costs subsequently fell and underwriting technology improved, however, lenders began to use estimates of default risk to assess different interest rates for individual loans. This paper examines both the extent and consequences of the increased use of risk-based pricing of interest rates in consumer loan markets during the mid-1990s. Put briefly, risk-based pricing is the practice of lenders charging each borrower a specific interest rate based on credit risk rather than charging one single house rate.
The paper tests three predictions based on these changes. First, the premium paid per unit of risk should increase. Second, debt levels should react accordingly. Third, fewer very high-risk households should be denied credit, further contributing to an increase in the spread between the interest rates paid by highest and lowest risk borrowers. In order to isolate the potential effects of risk-based pricing, I empirically model interest rate determination for a broad spectrum of consumer loans, allowing default risk to play a key role. I estimate the actual extent of default risk’s role in interest rate setting by using two sources of risk: the risk of being late on payments and the risk of bankruptcy.
On the whole, the results are in keeping with the predictions. For those obtaining loans, the premium paid per unit of risk became significantly larger over this time period, with the difference between high- and low-risk borrowers’ interest rates at least nearly doubling for secured loans and increasing for most unsecured loans, as well. Moreover, changes in borrowing levels and access to debt reflected these new pricing practices, particularly for secured debt. While the overall lower levels of interest rates generally boosted borrowing in the late 1990s, the demand for credit increased most for low-risk households who saw lower relative borrowing costs. In addition, these changes in pricing practices led to increased credit access for very high-risk households (again, particularly for secured debt), but the increase in the risk premium faced by these households also caused their average borrowing levels to either rise less or, for some loan types, to fall. In the end, changes in risk-based pricing may account for between 25% and 75% of increases in consumer debt levels for certain types of secured loans. And, these changes may more than account for the increased use of secured consumer debt by the highest risk groups.
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