What does “risk-based pricing” mean in lending?

"Risk-based pricing" in lending refers to the practice of adjusting loan terms, primarily interest rates, based on the creditworthiness of the borrower. This approach allows lenders to evaluate the risk associated with different borrowers and set loan terms that reflect the likelihood of default.

When a lender assesses an applicant's credit history and overall financial profile, they can identify the level of risk the borrower presents. Higher-risk borrowers may have lower credit scores or more outstanding debt, which could justify higher interest rates to compensate for the increased risk. Conversely, borrowers with strong credit profiles may receive more favorable terms, such as lower interest rates, reflecting their reliability and lower probability of default.

This method not only helps lenders mitigate potential losses but also incentivizes borrowers to improve their creditworthiness to access better loan terms in the future. It is a cornerstone of responsible lending practices, as it aligns pricing with the level of risk involved instead of applying a one-size-fits-all approach.