Guide to Risk Based Pricing

The UK is fortunate to enjoy one of the most diverse and competitive credit card markets in the world. Numerous banks and specialist credit card businesses continuously vie for our business, with a diverse range of products, each offering unique features designed to appeal to and benefit specific segments of the UK population.

However, whilst the advertised deals often look very enticing, they aren't available to everyone. Not all consumers have the same propensity to make the card issuers money, and repay what they have borrowed, so being able to offer headline-grabbing deals is at least as much about the applications credit card issuers reject as the accounts they open.

Depending on the issuer, the product, and the "score card", numerous customers are declined credit entirely, but there is also another group of applicants who are not entirely declined, yet are not offered the product that they applied for.

Although it is not necessarily widely understood, credit card issuers are only legally obliged to offer the rate that they have advertised to 51% of the accepted applicants. 49% of applicants can, at least theoretically, be offered an entirely different deal. Of course issuers could offer some of these individuals rates that are better than those advertised, but in practise this doesn't happen. Issuers set the advertised pricing of their products based on what they can offer to the top 51% of accepted applicants. This, of course, begs the question, "what are the other 49% offered?"

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Firstly it is important to point out that not all credit card issuers offer different rates to different customers depending on status. Some prefer to either accept applicants or decline them for products. However, those not offering alternative pricing potentially put themselves at a commercial disadvantage compared to those able to convert more potential leads into sales. So how do credit card issuers decide what to offer the potential 49% not getting the advertised rate?

Many lenders use a practice which is commonly referred to as 'Risk Based Pricing'.

What is Risk Based Pricing?

Risk Based Pricing is a method used by some credit card issuers whereby certain consumers are offered different interest rates or conditions to those advertised and is designed to reflect the increased risk of delinquency (bad debt) they pose to the issuer.

How do Credit Cards Issuers Determine 'Risk'?

As with the acceptance criteria for credit cards themselves, which differ between individual issuers and the products they offer, so the exact process for determining what product, rates and terms a customer is offered differs between issuers and products. However, there is some commonality of approach. Most issuers use a combination of elements such as credit score (or credit scores, if they access more than one credit reference agency), current level of debt and employment status/income, in conjunction with data from current and previous customers with similar circumstances. Using these numerous data points, credit card issuers can create sophisticated models which can show, with reasonable accuracy, the likelihood customers with particular traits and circumstances have of defaulting on their debts.

Factors such as race, religion, gender are not used as they conflict with anti-discrimination legislation.

Once issuers understand the risk(s) particular customer profiles present, they can adjust their pricing and terms to reflect it. Typically this means that customers who have lower credit scores are offered products with higher interest rates than those which customers with better credit histories can access.

Advantages of Risk Based Pricing?

Not all UK credit card issuers use Risk Based Pricing to tailor their rates, but for those that do there can be considerable advantages.

  • Often terms stipulate that transfers cannot be made to the total value of a given credit limit.
  • Risk Based Pricing offers issuers the opportunity to develop and market products designed for the top 51% of applicants. This means they can advertise very attractive products, safe in the knowledge that customers who present them with a higher level of risk will not be able to access the deal. Indeed, it was arguably improvements in determining the risk customers present, together with changes in the way that issuers had to display credit information, which reduced the percentage of customers an issuer needed to accept, from a 'typical' 66% of customers to a 'representative' 51%, that precipitated the record balance transfer lengths available today.
  • Although much of the benefit to be drawn from Risk Based Pricing undeniably goes to those who are able to access the best rates, issuers would also argue that pricing for risk also offers advantages to those who are offered alternative products, rates and terms, because without Risk Based Pricing these customers may well find that they are offered no credit whatsoever.

Disadvantages of Risk Based Pricing?

There are a number of disadvantages to consumers from Risk Based Pricing; predominately experienced by those unable to access the advertised rate:

  • Often terms stipulate that transfers cannot be made to the total value of a given credit limit.
  • Given that Risk Based Pricing enables issuers to offer potential customers better deals than they could if they were pricing products based on the behaviour of all accepted applicants, it naturally follows that individuals not able to access them get worse deals than they could access if issuers were compelled to offer pricing based on the aggregate behaviour of all customers.
  • Lenders are able to adopt different, largely unpublicised, criteria for assessing almost half of all borrowers, offering different and sometimes unpublicised APR rates.
  • Arguably, both of the issues detailed above are exacerbated further as Risk Based Pricing enables issuers to create highly attractive products that draw the maximum number of applications. And, given that the number of searches on a credit file tends to be viewed by lenders as indicative of financial wellbeing (i.e. a high number of credit file 'pulls' tends to be interpreted as an individual in financial difficulty), undue pressure is placed on individuals who are offered alternative products to accept them, given they may discover they are declined for alternative products from other issuers (at least in the near term).

Do Credit Card Issuers 'Re-price' Current Customers?

Because the credit associated with a credit card is open ended, in that it does not have a definitive end date (like a loan or mortgage), lenders periodically reassess the borrower's circumstances and can adjust the APR rate accordingly.

This is known as risk based re-pricing. Risk based re-pricing allows the lender to increase or decrease the interest as they perceive the borrower's risk alter over time. It is important to note that once the APR rate has been changed, this is applied to the entire amount of credit, not only future spending. This means that those customers whose financial behaviour improves (payments are made on time, decreased indebtedness etc.) may see a reduction in their APR, whilst those whose financial management is perceived to have become more risky (consistently only making the minimum payments, making cash withdrawals on their credit card, going over their credit limit) could see interest rate increases, reductions in the credit limit or changes to other terms.

Financial institutions can also increase a card's APR rate for other reasons, outside of the customer's financial behaviour. For example, changes in the wider economy leading to an increased cost of lending money. This is known as general re-pricing.


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