Loans and Credit: Risk-Based Lending, and How Loans are “Priced”

Loans and Credit: Risk-Based Lending, and How Loans are “Priced”

Risk-Based Credit

Risk-based lending permits creditors to develop loan interest rates that match their lending risk. For example, since loans are priced based on risk, the lowest annual percentage rates (APRs) are associated with conventional mortgage loans where borrowers make a minimum 20% down payment toward the purchase of their new home.  The APR expresses the annual rate of interest on a consumer loan, including any prepaid finance charges.  Mortgage loans may be lower-priced than other forms of consumer borrowing because the value of the property/collateral reduces risk for the lender, and the substantial down payment associated with conventional mortgages similarly lessens the probability that a deficiency balance will result if a foreclosure sale occurs. In contrast, unsecured credit card loans issued to consumers with blemished credit histories will likely carry high APRs, since not only is there a higher risk of default, but no collateral is offered to compensate the lender if a default does occur.

FICO Scores/“Credit” Scores

A borrower’s credit score is a major factor in how a lender will price a consumer’s loan. FICO is an acronym for the “Fair Isaac Corporation,” a for-profit company that provides a well-known credit score model in the United States.  FICO scores range from 300 to 850 (with a higher score indicating more creditworthiness), and are intended to predict the likelihood that the borrower will repay his or her obligations. Lenders such as mortgage companies, banks and credit card issuers use credit scores to help determine who qualifies for a loan, and at what interest rate. Since FICO scores are used by lenders to evaluate risk, consumers with high credit scores are generally offered lower interest rates and are more likely to gain approval when applying for auto, mortgage, and credit card loans. Both FICO and the major credit reporting agencies (Experian, Equifax, and Trans Union) furnish lenders and consumers with credit scores, for a fee.



   

Each year, our office receives numerous calls from frustrated consumers facing above-market interest rates on credit card, auto, mortgage, and personal loans. Even though these customers have diligently shopped for favorable loan rates, their poor credit histories and low credit scores have caused creditors to offer loans at high APRs. Unfortunately, their status as high-risk applicants has translated into high interest rate offers. To avoid further borrowing pitfalls, these consumers should only finance what they can comfortably afford to repay; and a combination of on-time payments and careful financial planning will eventually improve their credit standings.

Mortgage Loans (see Chapter Seven [page 31] for more details)

A mortgage is simply an installment loan where the lender agrees to provide a lump sum (loan proceeds) to buy a home in exchange for the borrower’s agreement to pay back the borrowed amount according to a re-payment schedule, and in which the borrower’s promise to repay the loan is secured by a lien on the house and land. APRs on a conventional mortgage loan, featuring a minimum 20% down payment, are among the lowest loan rates a consumer can obtain. Consumers with less than perfect credit, or who can’t afford to make a substantial down payment, often find themselves facing mortgage loans with higher APRs.  Mortgage loan terms typically vary from ten to thirty years.  Interest rates can be fixed or variable (i.e., can move up or down during the loan’s term).

Automobile Loans and Credit Sales (see Chapter Three [page 9])
Pursuant to the Maine Consumer Credit Code (Title 9-A of the Maine Revised Statutes), interest rates on credit sales of automobiles cannot exceed an APR of 18%. Just like consumers seeking a mortgage loan, car loan applicants with better FICO scores and larger down payments, improve their chances for loan approval and generally are offered lower interest rates. To increase sales, captive finance companies such as GMAC, Toyota Motor Credit and Ford Motor Credit periodically offer cut-rate financing (rates below market levels) to qualified buyers. Automobile credit terms generally range from 12 to 84 months.  These installment contracts generally feature fixed APRs.
Home Equity Lines of Credit (see Chapter Seven [page 31])
A home equity line of credit (HELOC) is an open-ended/revolving loan which allows consumers to borrow funds using their homes as collateral. This line of credit is secured against the equity in a borrower’s primary residence, and the consumer can choose when and how often to borrow against the equity in their property, with the lender setting an initial dollar limit to the credit line. The APRs on HELOCs are generally variable (can rise and fall), and are usually based on a certain number of percentage points (margin) above an “index rate” (a guideline interest rate that banks utilize in calculating appropriate rates for loan contracts).
Credit Card Loans (see Chapter Four [page 18])
The interest rates that credit card companies charge their customers can vary widely. Most credit cards are unsecured loans, meaning they are not backed up by collateral (bank deposit, auto, home, boat). Since there is generally no collateral pledged by the cardholder, and the loans are backed only by the borrower’s promise to repay, APRs are typically higher with credit cards than with secured loans, since the lender undertakes greater risk. Interest rates can range from the high single digits (8.9% or 9.9% APR), to over 30% APR. Shopping around and finding a credit card with a low interest rate can yield significant savings, and consumers with the highest credit scores should receive the best APRs. Like home equity lines of credit, credit cards are open-ended, revolving loans and have no fixed loan terms. While the APRs are technically fixed, rates can be adjusted up or down by the card issuer with 30 days advance notice.