Same Day Payday Loans

Risk–Based Pricing In Loans

A payday loan or cash advance paycheck loan is a short-term loan usually without a credit check. The usual amounts loaned are $500 and less. The purpose of borrowers why they take out payday loans is to bridge a cash flow gap. This gap could be due to unprecedented emergencies. But payday loans charge high interests. Because of the high interests, payday loans are not a recommended way of solving deeper financial problems. Yet, the high interests charged by payday loan lenders is actually based on a financial concept called risk-based pricing.

Risk-based pricing is a usual practice in the financial services industry. Some types of firms involved in financial services are banks, insurance companies, investors, brokerages, and financing companies. Essentially, they provide money, investment, and other related services.

According to the concept of risk-based pricing, a financial service industry may charge different interest rates on the same amount to different people. To categorize the “different” people, one of the bases of financial service firms is the person’s credit score and not income. Information regarding income is just used to determine if the borrower is asking for an amount that is higher than he can afford.

A credit score quantifies a person’s likelihood to satisfactorily pay his debt. People with high credit scores means that they are most likely able to pay the amount they borrowed. This is why they are entitled to lower interest rates. People with low credit scores means that they are less able to pay the amount they loaned. A finance company allowing such group of people to loan money faces a greater risk of not being paid back.. This is why these people are charged with higher interest rates.

From one point of view, such may seem unfair since those who are less financially able are facing more demanding interest rates. But if the interest rates are the same for all borrowers, those who are less likely to default payment will be shouldering the expenses of those who default. In a capitalist system, this is not fair at all. Risk-based pricing makes it possible for those with unblemished credit history to borrow at lower rates.

With payday loans, due to the urgent nature of the financial need, credit history and credit scores are no longer checked. Thus, payday loan lenders will assume that all their potential borrowers may default. The lender is facing a high risk of default. In such a situation, the logical action of lenders is to charge higher interests.

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