Risk-based pricing sticks it to the American consumer

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Thanks to federal regulations first ordered up in 2003 (but just recently finalized), consumers who go to borrow money will soon know if they are being charged a higher interest rate because of something unsavory on their credit report. As Kenneth Harney has pointed out, it would have been nice to have had this rule prior to the housing bubble:

With the rapid spread of risk-based pricing systems, fewer applicants were formally declined for loans; lenders simply raised rates to handle the perceived higher risk. The entire subprime mortgage industry — which lit the fuse for what eventually became the housing bust — rested on the ability of lenders to charge borrowers with low credit scores far more than they would charge consumers with high scores. Concerned that many loan applicants were being hit with excessive rates for no good reason, Congress in 2003 passed the Fair and Accurate Credit Transactions Act… The idea was to give consumers a red flag about credit-file complications before they were legally bound to a loan deal that might be overpriced.

The notion of risk-based pricing sticking it to the American consumer recently came up in another context: a story I did on why financial-literacy education doesn’t work.

That story is in this week’s magazine. You can read it online here.

As these things often go, there wasn’t enough space in the magazine to fit all of my brilliant reporting and prose. I’m glad to be able to restore part of it here:

The tensions and complexities of financial life—which have escalated over the past few decades along with financial innovation—have led some experts to question whether any sort of education will be sufficient. There used to be a time when a bank wouldn’t give you a mortgage unless it thought you could repay. Now you’re on your own in a system that knows how to make money off you even if you fail (think about credit-card late fees). “It’s a blame-the-victim mentality,” says Lauren Willis, a professor at Loyola Law School who has studied financial decision-making. “But it doesn’t sound like it if you’re just asking people to educate themselves.”

Justin and I have a long-running discussion about this. It’s not that people used to be more prudent and were able to impose restraint on themselves when they went to get a mortgage and buy a house. Rather, restraint was imposed on them by a lender that wanted its money back.

Yes, risk-based pricing means that a lot more people can have access to credit. But it also means that the rule of thumb for whether or not a particular person should have credit goes out the door. For a credit-card company, say, it doesn’t matter if five people in a pool of 100 risky cardholders wind up bankrupt—the other 95 are getting charged a high enough interest rate to offset the loss. For those five people, though, the result is catastrophic. I don’t know if it’s enough to simply tell people that they’re in that pool, as the government is now going to require companies to do, but at least it’s a start.