What does 'risk-based pricing' refer to in the context of banking?

Risk-based pricing in the context of banking specifically refers to the practice of setting loan interest rates according to the borrower's risk profile. This means that lenders assess various factors, such as credit history, income level, debt-to-income ratio, and overall financial behavior, to determine the likelihood that a borrower will repay the loan. Borrowers who present a higher risk due to poor credit or unstable income may be charged higher interest rates to compensate for the increased risk of potential default. Conversely, borrowers perceived as low risk are offered lower rates, reflecting their more favorable profile.

This approach allows financial institutions to manage risk more effectively and to ensure that the pricing of credit products is aligned with the borrower’s ability to repay, ultimately leading to a more sustainable lending model.