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Risk-based pricing of interest rates in household loan markets

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  • Wendy Edelberg

Abstract

Focusing on observable default risk's role in loan terms and the subsequent consequences for household behavior, this paper shows that lenders increasingly used risk-based pricing of interest rates in consumer loan markets during the mid-1990s. It tests three resulting predictions. First, the premium paid per unit of risk should have increased over this period. Second, debt levels should react accordingly. Third, fewer high-risk households should be denied credit, further contributing to the interest rate spread between the highest- and lowest-risk borrowers. For those obtaining loans, the premium paid per unit of risk did indeed become significantly larger over this time period. For example, given a 0.01 increase in the probability of bankruptcy, the corresponding interest rate increase tripled for first mortgages, doubled for automobile loans and rose nearly six times for second mortgages. Additionally, changes in borrowing levels and debt access reflected these new pricing practices, particularly for secured debt. Borrowing increased most for the low-risk households who saw their relative borrowing costs fall. Furthermore, while credit access increased for very high-risk households, the increases in their risk premiums implied that their borrowing as a whole either rose less or, sometimes, fell.

Suggested Citation

  • Wendy Edelberg, 2003. "Risk-based pricing of interest rates in household loan markets," Finance and Economics Discussion Series 2003-62, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2003-62
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    Citations

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    Cited by:

    1. Jonas D. M. Fisher & Martin Gervais, 2011. "Why Has Home Ownership Fallen Among The Young?," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 52(3), pages 883-912, August.
    2. William Adams & Liran Einav & Jonathan Levin, 2009. "Liquidity Constraints and Imperfect Information in Subprime Lending," American Economic Review, American Economic Association, vol. 99(1), pages 49-84, March.
    3. Jonas D. M. Fisher & Martin Gervais, 2007. "First-time home buyers and residential investment volatility," Working Paper Series WP-07-15, Federal Reserve Bank of Chicago.
    4. Magri, Silvia & Pico, Raffaella, 2011. "The rise of risk-based pricing of mortgage interest rates in Italy," Journal of Banking & Finance, Elsevier, vol. 35(5), pages 1277-1290, May.
    5. Athreya, Kartik, 2006. "Fresh start or head start? Uniform bankruptcy exemptions and welfare," Journal of Economic Dynamics and Control, Elsevier, vol. 30(11), pages 2051-2079, November.
    6. Liran Einav & Jonathan Levin & William Adams, 2007. "Liquidity Constraints and Their Causes: Evidence from Subprime Lending," 2007 Meeting Papers 52, Society for Economic Dynamics.
    7. Oleksandr Talavera & Haofeng Xu, 2018. "Role of Verification in Peer-to-Peer Lending," Working Papers 2018-25, Swansea University, School of Management.
    8. Gervais, Martin & Fisher, Jonas, 2009. "Why has home ownership fallen among the young?," Discussion Paper Series In Economics And Econometrics 0907, Economics Division, School of Social Sciences, University of Southampton.
    9. John A. Weinberg, 2005. "Borrowing by U.S. households. 2005 annual report of the Federal Reserve Bank of Richmond," Annual Report, Federal Reserve Bank of Richmond, pages 4-16.
    10. Kartik B. Athreya, 2004. "Shame as it ever was : stigma and personal bankruptcy," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 1-19.
    11. Mateos-Planas, Xavier, 2009. "A model of credit limits and bankruptcy with applications to welfare and indebtedness," Discussion Paper Series In Economics And Econometrics 0910, Economics Division, School of Social Sciences, University of Southampton.
    12. N. Narajabad, Borghan, 2010. "Information Technology and the Rise of Household Bankruptcy," MPRA Paper 21058, University Library of Munich, Germany.
    13. Charles Grant & Mario Padula, 2006. "Informal Credit Markets, Judicial Costs and Consumer Credit: Evidence from Firm Level Data," CSEF Working Papers 155, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
    14. Diego A. Restrepo-Tobón & Subal C. Kumbhakar, 2013. "Profit efficiency of U.S. commercial banks: a decomposition," DOCUMENTOS DE TRABAJO CIEF 010939, UNIVERSIDAD EAFIT.
    15. Wang, Fan, 2007. "Risk-Based Pricing of High Loan-To-Value Mortgage," MPRA Paper 4788, University Library of Munich, Germany.
    16. John A. Weinberg, 2006. "Borrowing by U.S. households," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 177-194.
    17. Astrid A. Dick & Andreas Lehnert, 2010. "Personal Bankruptcy and Credit Market Competition," Journal of Finance, American Finance Association, vol. 65(2), pages 655-686, April.
    18. Dynan, Karen E. & Elmendorf, Douglas W. & Sichel, Daniel E., 2006. "Can financial innovation help to explain the reduced volatility of economic activity?," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 123-150, January.
    19. Patrick de Fontnouvelle & Victoria Garrity & Scott Chu & Eric S. Rosengren, 2005. "The potential impact of explicit Basel II operational risk capital charges on the competitive environment of processing banks in the United States," Basel II White Paper 4, Board of Governors of the Federal Reserve System (U.S.).
    20. Mario Padula & Charles Grant, 2007. "Bounds on repayment behavior: evidence for the consumer credit market," Working Papers 2007_26, Department of Economics, University of Venice "Ca' Foscari".
    21. Mateos-Planas, Xavier & Seccia, Giulio, 2006. "Welfare implications of endogenous credit limits with bankruptcy," Journal of Economic Dynamics and Control, Elsevier, vol. 30(11), pages 2081-2115, November.
    22. Radnai, Márton, 2015. "A lakossági devizahitelek átárazásának bumeránghatása
      [The boomerang effect of repricing household foreign-currency mortgage loans]
      ," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(2), pages 113-138.
    23. Diana Hancock & Andreas Lehnert & Wayne Passmore & Shane M. Sherlund, 2006. "The competitive effects of risk-based bank capital regulation: an example from U.S. mortgage markets," Finance and Economics Discussion Series 2006-46, Board of Governors of the Federal Reserve System (U.S.).
    24. Oh, Joon-Hee & Johnston, Wesley J., 2014. "Credit lender–borrower relationship in the credit card market – Implications for credit risk management strategy and relationship marketing," International Business Review, Elsevier, vol. 23(6), pages 1086-1095.
    25. Til Schuermann, 2004. "Why were banks better off in the 2001 recession?," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 10(Jan).

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    Keywords

    Loans; Personal ; Households - Economic aspects;

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