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How lenders set interest rates?

Have you ever wondered exactly how lenders use credit scores and choose your interest rates? It’s actually quite a science. The process includes sophisticated lender systems that leverage factors including “risk-based pricing.”

When consumers get their credit scores, they generally focus on the number and not much more. However, when a lender pulls a consumer’s credit score, it focuses on what that number means in terms of credit risk specific to its business and the type of loan it’s offering. A credit score is a summary of a consumer’s likelihood to default on a loan; the higher the score, the lower the likelihood of default.

Risk-based pricing is a practice whereby a lender offers better deals to borrowers who pose less risk of defaulting. This is why consumers with higher scores are generally awarded lower interest rates, higher loan amounts and higher credit limits. They pose less risk to the lender, so the lender feels more comfortable offering them competitive pricing and access to larger amounts of money. Conversely, risk-based pricing may mean consumers with lower scores are either denied access to credit or are charged higher interest rates to compensate the lender for the additional risk and possible cost of collection. They subsidize the higher potential risk to a lender by paying more for credit. 

For example, a lender knows the odds of defaulting are much higher for an applicant with a fairly low credit score of 500 than for another applicant with a very high credit score of 780. The lender has a decision to make at this point. It can decline the applicant with the 500 or take a chance by approving his or her application. If the lender approves the application, it will likely grant a lower credit limit or loan amount to limit its risk, and charge a higher interest rate to help offset the cost of taking on greater risk.

Almost all lenders of all types use risk-based pricing to determine rates and other loan terms. In fact, some lenders will offer dozens of different “deals” depending on the applicant’s credit score.

So what’s a “good” credit score?

A “good” credit score is whatever score is necessary for a lender to give you its best deal. There isn’t any exact answer to the “what’s a good score” question, because that number varies by lender and by loan product. One lender might offer the best auto loan terms to consumers with credit scores at or above 720, while another might reserve the best auto loan deals for those with scores at or above 750. This underscores the importance of shopping around for the best interest rates.

In today’s credit environment, consumers with scores at or above 780 are generally considered low-risk and usually can qualify for the best terms and conditions, which could include zero percent balance transfer offers, zero percent auto loans, and mortgages with the lowest rates currently available.

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