Risk-Based Pricing Is A Myth

Credit card companies need to penalize bad behavior with outrageous fees to keep credit affordable for the rest of us, right? Yeah, not so much. Credit Slips blogger and Georgetown Law Professor Adam Levitin argues that risk-based pricing is a myth that credit card companies exploit to escape well-deserved government regulation.

As an idea, risk-based pricing isn’t all that bad: consumers pay for credit based on their risk. But with credit cards, only interest rates and late fees are arguably “risk-based.”

Interest rates are a terrible way to counter risk. Responsible cardholders never carry balances, so fiddling with their interest rates mean nothing. Kicking consumers with retroactive penalty APRs means that creditors failed to properly assess the risk in the first place; if creditors were truly risk based, they would respond to increased risk by slashing credit lines.

Late fees are equally terrible. Most creditors have three tiers of late fees. It doesn’t matter if you’re late by one hour or one month, even though the two clearly show different degrees of risk.

Or as Levitin puts it:

Suffice it to say that it is a real stretch to say that credit card pricing overall is risk-based; certain elements of card pricing are partially risk-based, but many are not. Moreover, there is no empirical evidence connecting the advent of risk-based pricing to lower costs of credit to creditworthy consumers or greater credit availability to subprime borrowers. There is a study that correlates late fees and overlimit fees with banks’ aggregate cardholder risk, as well as with banks’ market power, but there is no research connecting fee levels, which are often one-size fits all, with individual cardholder risk. The putative benefits of risk-based pricing depend on pricing being sensitive to individual level, not aggregate level risk, so that low risk cardholders don’t subsidize high risk cardholders.

In any case, the benefits that the card industry attributes to risk-based pricing are explained at least as well by other factors: lower costs of funds explain lower interest rates to creditworthy consumers (issuers’ annual net interest margin has been fairly static for the last two decades), and securitization is at least as good of an explanation for the expansion in subprime lending.

So why do credit card companies pretend to use risk-based pricing? To evade government regulation. Professor Levitin makes a convincing six-point case for the government to lasso creditors with powerful regulations, but we’ll let you read the full paper for yourself to see why.

The Credit Cardholders’ Bill of Rights [Credit Slips]
All But Accurate: A Critique of the American Bankers Association’s Study on Credit Card Regulation [SSRN]
(Photo: Getty)

Comments

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  1. RetailGuy83 says:

    Is that Ponch?

  2. famousmortimer78 says:

    I think it’s Dana Gould

  3. attheotherbeach says:

    Cool. Take ‘em out.

  4. u1itn0w2day says:

    Thank You!

    Didn’t NPRs The Secret History of the Credit Card say that the credit card companies want you to carry a balance.So if you throw in high price gouging interest or punative fees I guess the average card holder might be forced to carry a balance.But the rape me interest and fees are incentive to pay the balance off.The credit card companies want their cake and eat it to.They want their loan to you paid off yet they want to collect interest from you.Which is it?

    Can’t have somebody ban technicalities like universal default now can we?

    Either you want the loan payed off or want the credit card user to carry a balance to gouge them more.

  5. tankertodd says:

    This is an easy one. If you don’t like credit cards DON’T USE THEM! I have little sympathy for people getting gouged by their credit card companies. I haven’t paid more than $10 in credit card interest in 10 years because I live within my means. If others can’t do so I have no sympathy. Cut your cards or read Suze Orman or something.

    And the writer is wrong when he asserts that banks can control risk by playing with credit line only and not APR. The lender needs to get paid for his risk, so if you borrow $100 or $10,000 there needs to be an appropriate interest rate to cover the risk. Credit limits alone don’t do it, they simply limit exposure. The $100 loaned to the consumer is still at risk.

  6. u1itn0w2day says:

    I agree people should live with-in their means but it will never happen.The economy or an all cash economy would come to a screaching halt and need a I dare followed by a revolution of somekind.

    I also agree credit card companies need to get paid for their risk but how much is getting paid for their risk and how much is greed and gouging?.And as risky as credit cards might be they seem to be doing better than a the 50 page mortgages that these same banks issue.

    Which has more risk:increasing the size of the loan or letting a smaller loan stay out even if at a lower interest rate with the card user making payments?

  7. JollyJumjuck says:

    @tankertodd: It must be nice to have your life. Never lost your job unexpectedly, never took a financial risk that didn’t pay off, never had a serious health problem, never had your life partner financially give you the shaft…or maybe you’re a trust fund kid or have a sizeable inheritance. Or maybe you’re one of those people who found a rich partner and never had to work a single day. Ever.

    Simplistic answers like yours smack of little true life experience and the inability to understand others. “Live within your means” is sound advice. But don’t assume that everyone who is in debt is there because of their uncontrolled spending habits. Sometimes life hands you shit and you have to deal the best you can. Might as well say to a lottery player, “Why were you too stupid to pick the wrong numbers?”

  8. InThrees says:

    @tankertodd: Refusing an applicant credit period is another way of saying “You are too risky to extend any credit to at all.”

    I.E., the size of the credit line certainly is a risk-management tool. Logically a loan of $10,000 carries more risk than a loan of $1,000, all other factors considered.

    And… the same interest rate and payment rates on those loans will see a much higher return in the larger loan… there is your risk vs reward.

    I see what you are saying, in that APR is risk management, but so is limit… and limit makes MUCH more sense as a risk management tool.

  9. LJKelley says:

    Well I think part of the point is that if you have a limit of $1000 and you have borrowed $400 with an APR of 10% and you are slowly paying off and lets say you accidentally don’t return your Blockbuster video and they implement Universal Default and thus increase your APR to 20% which for sake of arguement you can’t afford and thus are likely to be late or default on your payment.

    The smart thing would be to either ignore such a stupid thing as a non returned video (of like $30 max value) and have no Universal Default or instead lower the limit to $500 which would decrease your ability to borrow more but still keep your ability to pay off the loan satisfactorly. So in this case, real risk management would only lower your limit and see that increasing your interest rate might be a bad thing.

  10. chuckv says:

    Why shouldn’t a company offering a loan (because that’s what a credit card is-you make a purchase and pay at the end of the month. In fact, if you pay your bills in full on time and never carry a balance, you are essentially receiving an interest free loan every time you make a purchase using a credit card. By not having to pay for your purchase until about a week or so after you make it, your money collects interest it wouldn’t have otherwise been able to collect had you paid with a direct withdrawal[debit.] The interest free loan concept adds up over time.) charge more for people who aren’t going to pay on time? If the companies really are gouging the hapless souls who voluntarily sign up for credit cards, why doesn’t anyone go into business offering slightly lower interest rates? If such gouging were the case, the “excess” profit would be competed out. If you were going to lend out your own money, would you charge more interest to the guy who everyone in your office knows has never reneged on a debt in his life, or the guy who always blows whatever he can get on the latest “toy?” It is wrong to expect credit card companies to lend out their shareholder’s money to anyone who asks at any interest rate. It is not credit card companies which are gouging their debtors, it is economic reality which is gouging overconsumers.

  11. famousmortimer78 says:

    @JollyJumjuck: This is why most financial advisers recommend an “emergency fund”, it’s not that people like tankertodd have no misfortunes in their lives, it’s that they know reversals will occur and plan accordingly- this is part of living within one’s means.

    On the whole I say people should use credit sparingly, keeping in mind that the credit companies are right-awful bastards who will take advantage of you if they can. But the continued availability of credit for everyone requires that it be profitable.

    So let’s keep lending profitable, and keep it on terms we can agree are just. The post at Credit Slips outlines 7 practices that would be limited by the CCBoR. I think it would be worthwhile to discuss which of these practices are truly unfair and which are not.

    Simply calling risk-based pricing a myth is just being sensational.

  12. TechnoDestructo says:

    @tankertodd:

    Someone who could pay off a 100 dollar loan without any difficulty may not be able to pay a 10,000 dollar loan under any circumstances. The risk changes with the size of the loan.

  13. nsv says:

    @JollyJumjuck: I probably sounded like him last year. I was never late with my payments, never charged more than I could pay off at the end of the month, had a great credit score.

    Then I was in a really bad accident.

    While I couldn’t physically move, for some reason, I didn’t put a lot of thought into paying bills. It’s funny how that works.

    After I dealt with the fallout from that (and it took months,) I set up an automatic payment to my credit cards for a small minimum payment every month.

    It came in handy this month. I was dealing with a family medical emergency, and I forgot about paying my bills. The payment went out as scheduled, the huge balance wasn’t touched (including all the travel expenses related to the emergency,) and I’m paying some serious interest, but my payment wasn’t late.

  14. The fault really lies with people who insist on buying things they do not need and giving in to Advertising temptation to have the latest and greatest gadget or fad.

    Or people using their debit cards as options -(with a thousand dollar a day limit – it should be no problem)

    The credit card firms can only exploit those who allow themselves to be exploited

  15. bohemian says:

    @JollyJumjuck: If you have a truly devastating life event a credit card is not going to save you, it is just going to be a very temporary band aid that will mushroom into yet another problem heaped upon the others.

    At least with an emergency fund after the money is spent your left trying to put money back into the emergency fund, not putting money back into the emergency fund plus 35% interest and late fees.

    The larger problem is people either live beyond their means or don’t quite make enough to save and meet basic month to month needs. For many the cost of living vs. wages has been eroding for decades.

  16. Pro-Pain says:

    @JollyJumjuck: OMG that was great. Big thumbs up!!! The response was funny too. Some people are such asshats.

  17. MrEvil says:

    The Emergency fund is sound advice too, however, don’t forget that here in the great old US of A there are places (Texas) where as much as one fourth the population has no health insurance. Now tell me exactly how you’re going to save up a year’s salary or more to cover medical expenses incurred due to an accident or you getting cancer? My dad was hit by some nutsack that wasn’t paying attention to a traffic light. Fortunately my dad wasn’t severely injured, but 9 months later he still hasn’t seen a dime from the insurance company to cover visits to the orthopedic surgeon. At least we don’t have a vehicle in need of repair (my old man was driving a work vehicle).

  18. chrisjames says:

    @JollyJumjuck: Let’s throw the tired old “Credit for Emergencies” argument away, since it has no place in the context of this article. We should all have at least a small credit line sitting around for emergencies, but that’s no different than having a little money kept in a savings account, or an investment account, for just that purpose. In absence of the ever-dreaded emergency, the proper course is to never spend any of that money, be it savings, investments, or credit. If, or sometimes when, the emergency does come around, the last thing you should worry about is how you’re going to pay for it, meaning this talk of this or that APR, or this or that taxation rate, is all meaningless. It’s an emergency, the rules flew out the window. Otherwise, live within your means.

    Back to the point: Risk-based pricing? If anyone actually believed in such a thing, how could you believe that it was okay? The credit card companies can milk the risky borrowers? Who decides which borrowers are risky, who makes the call on which borrowers will be drained, and who’s to define risk? The credit card companies, fools. If not them, then the government, or some other faceless entity you’ll rant against while buying their service. By accepting the idea of risk-based pricing, and only the idea is necessary, you put the whip in the hands of the slave-driver and ask him to spare you at the expense of the guy next to you.

  19. johnva says:

    @chrisjames: I disagree that risk-based pricing is “slavery”. In fact, it’s the bedrock upon which modern credit markets rest. Simply put, if you are a higher credit risk, you should expect to pay more for loans, and if you’re a lower risk, you can demand to pay less. Lenders (and by extension, investors in bonds that securitize loans) will demand a higher interest rate to compensate them for a higher risk. This is the reason why subprime borrowers pay a higher mortgage rate, why junk bonds have to carry high interest rates to get anyone to buy them, and why you wouldn’t invest in the stock market (a higher risk proposition) unless you felt that you could make more money than in a federally insured bank account (a lower risk proposition). Assuming things are working properly, and not being manipulated artificially, higher interest rates should naturally discourage high-risk borrowers from borrowing more than they can handle. Anti-usury laws may actually prevent this process from taking place or cut off availability of credit to high-risk borrowers.

    That being said, I agree with much of the article’s premise that credit cards don’t really use much “risk-based pricing”, except indirectly. A lot of people who use credit cards pay nothing and essentially get free loans, despite the fact that they obviously are still a risk, even if just a small one. And while interest rates ARE often tied to credit scores, it’s true that the penalty rates often don’t kick in until after the fact, negating the effect of discouraging high risk borrowers from getting into so much debt in the first place. If we truly wanted them to use risk-based pricing, they probably would have to eliminate grace periods, charge interest rates over a much larger range, and make super-high-risk borrowers have these high rates from the start instead of after the fact.

  20. Sasha_Pie says:

    @Public Relations: Sure, everyone should live within their means and have a 6-month emergency fund… And I’m looking forward to the day when I can save that much… but for some people, me included, it’s not realistic to be able to save a considerable amount of money if you’re already paying a ridiculous amount in debt interest every month.

    Two years ago, my fiance stayed for 6-8 months too long at a job that wasn’t paying him regularly, but was run by a very close friend. Out of loyalty, we tried to hang on until “business got better” and during that time we put a lot of money on our credit cards, for things like food and car insurance, not luxuries. Eventually he had to leave and get a new job, but the damage was already done. Our credit card payments were out of control, and a series of car problems later, we’re barely hanging on. We’re currently staying with a family member to sort ourselves out and look for the most reasonable living situation we can find, but it’s going to be a while before we can build the kind of emergency fund that we want and pay down enough debt to be able to live within our means.

    It’s soul-crushingly frustrating when you’re trying to get your life back on track and pay down debt, and what seems like every month, another one of your interest rates is going from 9% to 22% through no direct fault of your own (never miss a payment, always pay more than the min)… and what used to be $100 in interest is now $250 per month. It’s a self-fulfilling prophecy to raise interest rates on someone who is “high-risk” because it becomes increasingly difficult for them to pay.

  21. SOhp101 says:

    Levitin, ALL of the finance industry’s interest rates are risk based. No one wants to lend to a potential defaulter without there being some incentive, and that’s just the way it is.

    Also, they’re giving you a large loan solely on the basis of your credit report and your ‘promise to pay.’ Neither of these can be considered collateral, so therefore there’s even more risk involved.

    That being said, I personally think credit is just a modern form of indentured servitude. You need to be careful, otherwise once you’re stuck, you’re stuck for a real long time.

  22. Mr. Gunn says:

    I’m not for government regulations covering everything, but companies have to exercise a certain amount of forbearance if they want that to keep from happening. If the credit issuers were assessing risk properly in the first place, they’d be offering smaller lines to less people, rather than raking in overlimit fees and late fees from the people who are the worst risk. If they were doing this, they’d be making less profit, but they wouldn’t be risking governmental intervention, so it’s probably a better idea for them to rein in issuing cards to every man+dog.

    Except Crapital One. Their notorious for low limits, so as much as I hate them, I can’t fault them too much here.

  23. Scuba Steve says:

    It’s not really a high point for corporate responsibility in this country, I’ll doubt we’ll see any sort of “lassoing” for a good 10 years or more.

  24. johnva says:

    @SOhp101: I totally disagree that credit is really anything like indentured servitude. If you were an indentured servant that refused to work, you might well be thrown in jail or physically beaten. If you don’t pay your credit card bill, the worst thing that’s going to happen to you is that they will sue you and take things you own or money you earn. That could still be harsh and life-altering, but it’s not on a level with being thrown in prison, beaten up, or basically sold like human property and involuntarily relocated, etc. And we ostensibly still have bankruptcy protection when we’re talking about credit cards, though that admittedly has been weakened by various lending industry lobbying efforts. Let’s keep some perspective here.

  25. incognit000 says:

    I think the real story here is that credit card companies will do anything and say anything to squeeze every last penny out of your pocket.

  26. dragonvpm says:

    It seems to me that Risk Based Pricing is another good example of how CC companies stack the deck in favor of their profits and against the average consumer.

    That’s not to say that consumers shouldn’t be more frugal and careful with their finances or that RBP doesn’t do something to help mitigate the increased risks that CC companies expose themselves to by lending to high risk consumers, BUT everyone who is defending the CC companies or blaming the consumers seems to ignore the fact that the most obvious benefit for RBP comes in the form of increased profits to the CC companies, and those profits are made on the backs of consumers under the guise or “protecting” the CC companies. That they can do some hand waving to explain why they do it is irrelevant, there are BETTTER ways for them to minimize their risks from bad consumers, but none of the better options makes them anywhere near as much money so of course they won’t implement those.

    What’s worse, I’d argue that this isn’t a unique situation, but rather, it’s the NORM. Just about EVERYTHING the CC companies do is geared towards making them as much money as possible regardless of what happens to the customer/consumer. Their biggest fear really isn’t that consumers might default on their CCs, but that the government might step in an put the brakes on their “anything goes” approach to making money.

  27. Erwos says:

    @chrisjames: “Risk based pricing” (better known as “risk vs return”) is more or less the premise of our entire financial system. It doesn’t put anyone into slavery.

    I mean, seriously, if you knew of two people, one a semi-serious default risk, and the other not, would you really lend them money at the same rate? Would you buy a riskier stock instead of a “safer” one if the return was the same? Would you work in a dangerous job for the same pay as a safer one (holding all else equal)?

    “Risk based pricing” is natural and common sense.

    As for who makes the decision that someone’s risky, that’s generally done statistically. If you think a credit card company has given you an unfairly high risk rating, I’d suggest you go to a different one. That’s what I did when my credit union said no to giving me a credit card, despite having a ton of money in the bank.

  28. chrisjames says:

    @Erwos: Dammit, I can’t type it all out again. Damned Consumerist eating my posts. Bullet points:

    - I was only using the slave-driver as a visual. The whip was the point of comparison. I don’t believe anyone is a slave to their creditors.

    - Risk-based pricing only works when the borrower and the lender are open to negotiate up front.

    - The credit card companies are the only ones that can decide what makes a borrower good or bad, or low or high risk. By agreeing to such a proposal, you agree to be subject to their whims. What you’re agreeing is that it’s okay to punish the bad while rewarding the good, which is hopefully you, but you’re neglecting that they can change that concept at any time and make you the bad if that’s what it takes to make some money. That’s just business.

    - My issue was with the idea of accepting risk-based pricing for credit card companies. You’ll always be under their rules, under their whip, but you shouldn’t believe that you can be rewarded at the expense of others, because they are the ones who decide who to punish. Don’t give them the whip.

    - The only way out is to switch companies, which is always an open option, but so long as you believe in the idea of risk-based pricing, you’ll end up subject to their whims again. Believe that you deserve the best deal you can get, and reject all those unworthy. In other words, turn the tables on the credit card companies and show them how business really works: negotiation.

    It just doesn’t seem to say the same things as the first time I wrote it, but I can’t muster the words a second time. Sorry.

  29. Erwos says:

    @chrisjames:

    “The credit card companies are the only ones that can decide what makes a borrower good or bad, or low or high risk.”

    Sure. They’re lending you their money. They’re entitled to that decision.

    I don’t see what your alternative is, honestly. Are they supposed to ignore relative risk, and just treat everyone the same? Because, frankly, they’d all close up shop, and rightfully so.

  30. chrisjames says:

    @Erwos: There is no alternative. But that doesn’t mean you have to believe they’re somehow working in your best interest, or that you can get in their good graces through good behavior.

  31. ltlbbynthn says:

    High interest rates go to people with low credit scores because people with bad credit are willing to pay more for credit. People with good credit have the luxury of shopping around for the best cards for them, but if you have bad credit you have to accept the only bank which offers you an account. Banks know they can screw over poor people. How is this news to anybody?