The Definition of "Risk Based" Underwriting

Some borrowers are more creditworthy than others. That is why lenders are willing to offer the lowest interest rates to people who have the best record of repaying their bills and debts on time. Lenders and other financial institutions such as insurance companies use "risk-based" underwriting to either set or adjust the price and other credit conditions for a particular borrower or client based on that person's credit history. Anyone applying for an insurance policy or any type of loan, including mortgages, cars or credit cards, can expect that the rate they are offered is based on risk-based underwriting. In the age of advanced credit scoring systems and major credit bureaus, risk-based underwriting has become a standard practice in the financial industry.

Risk-Based Pricing Rule

As of Jan. 1, 2011, every creditor must send a risk-based pricing notice to any consumer who has either been turned down for credit or was offered a higher interest rate due to his credit history. The notice will explain why the institution made an adverse decision on the loan request, and lenders also are required to provide consumers with the three-digit credit score that was used to reached the credit decision. The rule, issued by the Federal Reserve and the Federal Trade Commission, is intended to shed more light on the loan approval process so consumers who are turned down for credit or receive poor terms have more information concerning how they can make improvements to their credit profile.

Other Factors

When financial institutions use risk-based underwriting to evaluate a credit application, the credit score is not the only factor considered. Underwriters also take a close look at a person's income, his occupation and his length of time on the job. Combining all those elements in the risk-based pricing process helps build a better picture of who the applicant is and what level of risk he may pose.

Housing Industry

Risk-based underwriting has become more important than even in the housing industry since the sub-prime collapse in 2007. Since then, the largest purchasers of residential mortgages, Fannie Mae and Freddie Mac, have made changes to their risk-based pricing criteria, which require borrowers to have higher credit scores and more equity in order to qualify for a loan. Home buyers with poor credit histories and less than 20 percent to put down will either be rejected for a mortgage or must pay additional fees. In this instance, risk-based underwriting has raised the standard for people to qualify for home purchases and caused many existing homeowners who do not meet the standard to be unable to refinance higher interest loans for a better rate.

Insurance Industry

Insurance companies use your credit score to determine how much you will pay for insurance, which is another form of risk-based underwriting. Missing payments on credit cards can lead to you paying higher premiums or even having a policy cancelled with an insurance company you've been with for a long time. Insurance companies also will use risk-based pricing to assess how certain perils might affect a customer's profile. A single homeowner's risk profile is always changing, and there are times when the premium is adjusted for perils such as fire risk, water damage and the potential for theft.