Risk-based pricing is a methodology adopted by many lenders in the
mortgage
A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any pu ...
and
financial services
Financial services are the economic services provided by the finance industry, which encompasses a broad range of businesses that manage money, including credit unions, banks, credit-card companies, insurance companies, accountancy companie ...
industries. It has been in use for many years as lenders try to measure loan risk in terms of interest rates and other fees. The interest rate on a loan is determined not only by the
time value of money
The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money now rather than an identical sum later. It may be seen as an implication of the later-developed concept of time preference.
The ...
, but also by the lender's estimate of the probability that the borrower will default on the loan. A borrower who the lender thinks is less likely to default will be offered a better (lower) interest rate. This means that different borrowers will pay different rates.
The lender may consider a variety of factors in assessing the
probability of default
Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations.
PD is used in a variety ...
. These factors might be characteristics of the individual borrower, like the borrower's
credit score
A credit score is a numerical expression based on a level analysis of a person's credit files, to represent the creditworthiness of an individual. A credit score is primarily based on a credit report, information typically sourced from credit ...
or employment status. These factors might also be characteristics of the loan; for example, a mortgage lender might offer different rates to the same borrower, depending on whether that borrower wished to buy a single-family
house
A house is a single-unit residential building. It may range in complexity from a rudimentary hut to a complex structure of wood, masonry, concrete or other material, outfitted with plumbing, electrical, and heating, ventilation, and air ...
or a
condominium
A condominium (or condo for short) is an ownership structure whereby a building is divided into several units that are each separately owned, surrounded by