Risk based lending in the United States
|Topics:||💵 Finance, Discrimination, Social Justice, 🤔 Poverty|
Risk based lending happens in the acquisition of loans by borrowers whereby, lenders give different borrowers different rates of interest on loans or other loan terms by estimating the risk that the consumer will not repay their loans (Staten, 2014). The implication is that lenders give a higher rate of interest to a person who is considered to be a high risk borrower. For example, a borrower who is bankrupt, jobless, or has not updated his mortgage payments is seen to be of higher risk than other borrowers. For the same amount of loan, a lender can offer a borrower a lower rate of interest if the borrower is seen to be of lower risk. For example, such a borrower could be one that is employed or has a good credit history (Seidman 1998). Every lender employs his own method of determining the risk that a borrower can default on a particular loan. However, many of them use factors such as the credit score of the borrower, income, debts and employment status.
In the United States financial system, banks are some of the institutions that most commonly employ risk based lending. For example banks issuing credit cards use risk based lending (Wilson & Liñares-Zegarra, 2012). Other financial institutions that issue credit cards also use this strategy. In such cases, card holders classified as high risk, receive credit cards at a higher annual percentage rates of interest as compared to the low risk card receivers.
Another example in the U.S is the credit unions. Credit unions have been offering risk based lending services since the 1990s (Condon, 2006). At credit unions, people considered to be high risk borrowers are subjected to higher interest rates than those known to have perfect credit payments. However, the interest rates of high risk borrowers are lower than those they would get at pay day lenders and finance companies. Credit unions charge higher interest so that they can recover the high costs of collecting loans, servicing and underwriting.
Poverty Reduction and Access to Financial Services
Risk based lending is a way of poverty reduction. Risk based lending provides expanded borrowing opportunities, whereby consumers that have lower credit scores can get the goods and services they desire (Condon 2006). Over the last 30 years, millions of families in the United States have accessed credit which they use to purchase cars for driving to work, homes for raising their families and education for their children (Staten, 2014). People with small businesses use credit to purchase equipment and other necessary materials. They can also use it to pay their employees.
Responsible consumption through the use of credit is a major driving factor for the growth of the American economy. These benefits result from the pressure in the lending industry caused by stiff competition (Seidman, 1998). In the U.S, borrowers rent apartments, buy mobile phones, and rent vehicles without having large deposits or a strong relationship with their service providers. This is so because they have a good reputation of paying based on agreement and this is reflected in all their credit reports.
Discrimination in Risk Based Lending
Risk based lending may look discriminatory, but it is not. It is only a fair way of giving out credit to needy borrowers. Risk based lending makes it possible for lenders to charge higher rates of interest to borrowers that have a higher likelihood of defaulting. Those consumers with a higher likelihood of repaying loans to the full and in good time get lower interest rates. This system is fair because the bulk of credit decisions are made based on objective data about the past payment records of a borrower and his existing obligations (Bybee, 2011).
Using credit scores and risk based lending significantly determines how the lending decisions of a creditor will look like and the possibility of applicants being subjected to equal treatment. Consequently, consumers in America have access to credit, insurance and many other financial services by the lender considering the borrowers own credit record. It does not depend on the length of their relationship with their bankers or their family names.
In comparison to the system in which “one price fits all,” a consumer in a risk based lending market will also not be required to pay for costs that have been imposed by the behavior of another person (Condon, 2006). In addition risk based lending tends to reward those borrowers who are able to adjust their behavior. A consumer can get a loan with a lower interest rate when they decide to improve their credit behavior and financial position.
In conclusion, risk based lending is commonly applied to borrowers seeking loans from banks and other financial institutions based on their level of risk The strategy is important in poverty reduction because it makes credit available for use on domestic needs as well as for business purposes. The system is not discriminatory because it is based on the credit scores of each individual borrower.
- Bybee, J.R. (2011). Fair Lending 2.0: A Borrower-Based Solution to Discrimination in Mortgage Lending, 45 U. Mich. J. L. Reforms 113. Available at: http://repository.law.umich.edu/mjlr/vol45/iss1/3
- Condon, M.A. (2006). Best Practices. Risk-Based Lending: More Members, More Loans. Credit Union National Association.
- Seidman, E. (1998). Risk-Based Pricing: Promise or Perdition for Affordable Home Ownership? San Francisco, California: Neighborhood Reinvestment Training Institute.
- Staten, M. (2014). Risk-Based Pricing in Consumer Lending. Center for Capital Markets Competitiveness: University of Arizona.
- Wilson J. & Liñares-Zegarra, J. (2012). Working Papers in Responsibile Banking and Finance. University of St. Andrews.