Unlocking the Risk-Based Pricing Puzzle: Five Keys to Cutting Credit Card Costs

Article excerpt

The introduction of risk-based pricing has substantially changed the U.S. credit market. Although this "democratization" has provided credit to many underserved populations, these sophisticated pricing schemes leave many consumers wondering how to get the best price. Using the 2004 Survey of Consumer Finances, we specifically looked at credit card interest rates to determine the effect of selected financial behaviors that are within the control of consumers. For consumers who revolve a credit card balance, we found five tips to lowering their interest rate: (1) pay bills on time, (2) pay off credit card balances, (3) decrease credit utilization ratios, (4) become more financially educated, and (5) shop around more for credit. If consumers implement these tips, they can reduce their credit card interest rate and the amount of interest they will have to pay.

Introduction

Credit markets have changed substantially over the past 20 years. The decision to grant credit has changed from a "yes or no" decision for lenders to a "yes, but at what price" decision in a risk-based pricing environment. Legislators who passed the Fair Credit and Charge Card Disclosure Act of 1988 probably never anticipated subprime credit markets, universal default, or "penalty" interest rates that can exceed 30 percent. Nor may have they anticipated levels of outstanding credit card debt growing from $329.9 billion in 1988 to $840.8 billion in 2006 (constant 2006 dollars, Federal Reserve Board, 2006).

The concepts of risk-based pricing and "penalty" interest rates are interesting for policymakers and consumer educators for a variety of reasons. Although we know these pricing policies exist, we need to better understand how credit card issuers define risky behavior and, consequently, how these behaviors affect the annual percentage rate (APR) received by consumers.

Using data from the 2004 Survey of Consumer Finances, the goal of this paper is to examine the extent to which risky behaviors are reflected in the APRs charged to consumers on their credit cards. We pay special attention to the behaviors that can be controlled and changed by the consumers themselves. Identifying these behaviors will help consumers modify their behaviors to reduce the APR on their credit cards, saving thousands of dollars in interest payments on credit card debt over time.

Background and Previous Studies

The way financial institutions price their products has undergone a transition to risk-based pricing. This type of pricing structure is only recently possible due to a number technological improvements and innovations. These recent innovations include automated credit scoring, growth of asset securitization, and more flexible underwriting models while the technological improvements have reduced the cost of providing credit, including reductions in data storage costs (Bostic, 2002). These advancements have increased competition among lenders during the 1990s (Getter, 2006), which has encouraged lenders to offer credit to marginal borrowers (Lyons, 2003) in order to increase or maintain their market share. As the technology of providing credit has advanced, so has the way lenders price their credit products. Lenders can now segment the population between low-risk and high-risk borrowers based on their credit score, charging different rates based on risk. The higher the risk of the borrower, the higher the interest rates the lenders will charge to compensate for the possibility of delinquency or default (Cutts, Van Order, & Zorn, 2000). This pricing strategy has allowed households traditionally considered credit constrained, especially minorities and low income households, to gain access to credit products that they were previously denied, albeit it at a higher cost. This expansion of available credit to more individuals that occurred during the mid-to-late 1990s has become known as the "democratization of credit" (Lyons, 2003). …