Imagine, you and your friend earn equal salaries. Both of you have loans and pay the monthly instalments on time. But, let us assume you borrowed ten times more than your friend did. So, even though both of you are making timely repayments, your credit score would be lower compared to that of your friend’s due to excessive borrowing. Now, this will lead to higher interest rates being charged in your case for, say, a home loan. This is because some of the banks are now arriving at interest rates for loans using risk-based pricing.
What is risk-based pricing?
The Reserve Bank of India (RBI) announced that, effective October 1, all banks should adopt the repo rate as an external benchmark for pricing their floating interest rate loans. It also allowed banks to charge a credit-risk premium over external benchmarks for calculating the effective interest rate. This makes the credit score of borrowers an important factor in determining the interest rates on loans.
Risk-based pricing of loans is a system of offering credit at a rate depending on the customer’s credit score. Banks segregate borrowers based on their risk profiles. A retail banker, requesting anonymity, says, “After adopting risk-based pricing, we expect to on-board good quality borrowers on our books, and also retain quality borrowers by rewarding them with lower rates.”
Sujata Ahlawat, Vice President and Head, Direct to Consumer Interactive, TransUnion CIBIL explains, “It is basically preferential pricing that is offered by some of the banks to reward the borrower’s good credit behaviour with low interest rates.” Banks are considering past credit history of the loan applicant using third-party credit scores to derive default probability.
For instance, if in a bank’s credit profile, you are deemed to have a higher probability of default due to excessive borrowing, you will now be charged an additional premium on interest rates due to higher credit risk.
With risk based pricing, borrowers with low credit scores (less than 759) are required to pay a higher rate on a home loan and borrowers with high credit scores (over 760) are rewarded by banks with lower interest rates.
Risk based pricing has been adopted by Bank of Baroda, Union Bank of India and Syndicate Bank among others. They are using credit score from Credit Information Bureau (India) Ltd (CIBIL) to price new home loans. Further, State Bank of India (SBI) derives the risk grade of borrowers based on internal assessment and credit score inputs from credit bureaus. Gaurav Chopra, founder CEO of IndiaLends says, “Risk-based pricing has been happening with the private/multinational banks for a long time. It is essentially personalised credit rates that they're offering to borrowers.”
How does it work?
Bank of Baroda uses three credit score slabs from CIBIL to offer three home loan versions. CIBIL scores range from 300 to 900, with 900 indicating a high level of creditworthiness, while and 300 is considered a low score having high credit risk.
Customers with a credit score above 760 (out of 900) would pay 8.1 percent interest on new loans. Those in the lowest 675-724 range would pay 9.1 percent and those in the middle range of 725-759 will be charged 8.35 percent.
Union Bank of India charges 10 basis points (bps) more to customers with credit scores below 700. Similarly, Syndicate bank has decided to increase the credit risk premium if a borrower’s CIBIL score were to drop by more than 50 points.
SBI has categorised borrowers into six risk grades ranging from one to six for salaried and non-salaried borrowers. The borrowers in the risk grade of four to six will have to incur 10 bps more than borrowers in the risk grade of one to three. (Refer table)
Factors affecting pricing
Having a good credit score just at the time of borrowing would not suffice. You need to maintain a reasonable credit score throughout the tenure of the loan. Interest rates keep fluctuating based on a change in credit score. In case the credit score falls, banks increase the interest rate.
Says Ahlawat, “In risk-based pricing, your credit score is affected in case there is delay in instalment payments/paying credit card bills or loan settlements.” For instance, interest rates change for a borrower from Syndicate bank in case she delays monthly instalments for more than 30 days three times in the preceding one year.
Also, avoid applying for unsecured or personal loans, multiple credit cards if you don’t need them, as such moves could lower your credit score.
Says Chopra, “If you improve a credit score during the tenure of loan and get a one per cent reduction in interest rate from your lending bank you could save lakhs on a long-term loan.”
Let’s say you apply for a home loan of Rs 1 crore with 20 years tenure. Your credit score is 700 and applicable interest rate is 9.5 per cent as calculated by the bank. In this case, the monthly instalment payable is Rs 93,213. Within a year, if you manage to improve your credit score from 700 to 800, the bank may pass the benefit for having improved your credit profile by reducing the interest rate by one percent. In this case, the monthly instalment will reduce to Rs 86,782. So, there is an immediate saving of close to Rs 6,400 that comes from this one percentage point reduction in interest rates. Over the tenure of the loan, you will save Rs 10 lakh approximately.
You could check your credit report from four bureaus – CIBIL, Equifax, Experian and CRIF High Mark. There are several websites of loan aggregators such as IndiaLends, PaisaBazaar and Bankbazaar that provide credit reports as they have tied up with these bureaus.
Risk-based pricing of loans is a win-win for both the banks and borrowers. Here, banks are able to evaluate the risk of a borrower before offering a loan at a particular interest rate; also borrowers with good credit scores benefit from lower interest rates. You should maintain a credit score of 760 and above throughout the tenure of the loan to get a benefit.
While maintaining a credit score you need to keep a track of your credit report on a regular basis.