Credit Risk Management Practice Exam

In risk-based pricing, what do lenders do regarding pricing for different risk levels?

1. Keep prices constant across all borrowers

2. Charge higher prices to lower risk customers

3. Charge different prices based on risk profiles

4. Eliminate the pricing difference altogether

The correct answer is: Charge different prices based on risk profiles

In risk-based pricing, lenders evaluate the creditworthiness of borrowers and charge different interest rates or fees based on their individual risk profiles. This method recognizes that borrowers present varying levels of credit risk and adjusts the pricing structure accordingly. For example, a borrower with a strong credit history and a high credit score poses a lower risk to the lender; thus, they may receive a lower interest rate. Conversely, a borrower with a poor credit history or a high likelihood of default is seen as a higher risk, and as a result, they would be charged a higher interest rate. This approach allows lenders to manage risk effectively by aligning loan pricing with the estimated probability of repayment, thereby protecting their profits and reducing the potential for losses. The other options do not reflect the principles of risk-based pricing. Maintaining constant prices across all borrowers ignores the risk differentiation needed to ensure profitability and lend responsibly. Charging higher prices to lower risk customers contradicts the fundamental objective of risk-based pricing, which is to incentivize good credit behavior. Eliminating pricing differences altogether would undermine the lender's ability to assess risk accurately and would likely lead to increased default rates, further damaging the lender's financial stability.