If you have ever applied for a credit card or loan you may have noticed that the advertised rate of interest is often described as the typical rate. This mean that the provider uses a strategy called risk-based pricing, which means that even if you are accepted for the credit card you maybe offered a higher rate of interest then the one you have seen advertised and this is because you are perceived as being a higher risk customer.
But its not just new customers that are affected by risk based pricing, existing customers can also be affected because credit card companies can change the rate of interest they charge you at any time.
There has recently been quite a lot in the press about Egg, as it has recently contacted thousands of customers informing them that their rate of interest will increase from the beginning of March. I have got an Egg card and my rate of interest is going up from 12.9% to 16.9% - a 4% increase. But on our forums we have had a lot of people talking about even bigger increases of 6 or 7%. So why are some people being hit by a higher increase then others?
Peter Harrison, who is a credit card expert at moneysupermarket.com is with me to explain exactly what risk-based pricing is, how it works and why credit card firms are able to change the interest rates they charge to existing customers particular at a time that we are in at the moment when the Banks of England slashing the countries official rate of interest.
Q1: So Pete can you just go back to basics and explain exactly what risk based pricing is, why it’s used and how it works?
Peter Harrison: Okay, well risk-based pricing applies to both new customers and existing customers. When you’re applying for new credit card, one of the key things which does happen is that the interest rate is actually shown on some of the key summary details. The interest rate is known as the annual percentage ratio, and that’s the level of interest that you actually pay.
When you apply for a credit card, the credit card provider will then do a credit check on you, with bureaus such as Experian and Equifax, and then they’ll determine the likelihood of you being accepted for their application.
Some other factors that they do include are the likes of income, household status, marital status, and the level of debt you have on existing loans and cards.
Q2: And they look to see whether you have been able to manage that debt and if you have missed payments or been late making payments?
PH: Exactly that. In terms of if you have sort of defaulted on not being able to pay an existing loan - that would be included in your credit record.
Q3: And obviously that then determines a) whether or not you are accepted for the credit card or loan you are applying for but it also effects what interest rate you are going to be charged because the rate you would see advertised is call the typical rate isn’t it?
And if you see that sign it means that you might be charged a higher rate then that, can you explain why?
PH: The typical rate has to be given to 66% of consumers. The remaining actually does depend on your individual credit circumstances. So credit card providers can actually increase the interest rate according to whether you’ve defaulted on previous credit.
Q4: So if they deem you to be a riskier customer but not too risky, so they are willing to give you a card, say you see an advertised typical rate of 16.9% it may be that you are offered a rate of 19.9% or something that?
PH: That it, yes, exactly.
Q5: And it’s not just at the time of applications that this can have a factor is it? Because what we have seen recently is that we are seeing credit card providers increase the interest rates that they charge to existing customers and its not just, everybody is going to see their interest rates go up by 4% for example as has happened to me recently with my Egg card, but some people might see a 4% increase, other people might see a 6% increase, other people might see a 7 or 8% increase. Why are they altering it because surely when they have assessed initially then it’s a level playing field isn’t it?
PH: Unfortunately it isn’t, no. After you’ve actually taken out your credit card, the providers will actually do regular checks, understanding things like purchase behaviors and also understanding whether [you] possibly have defaulted on existing loans and cards, and what that can actually do is trigger the computer and flag you up maybe as an increased risk which therefore you have to determine. Then unfortunately the credit card providers do have the right in the terms & conditions to increase interest rates.
Q6: Now this is something a lot of people will really struggle to perhaps understand or feel is justifiable because obviously at the moment we are in a period where the Bank of England had been slashing interest rates and they are at an historic low and yet we are seeing credit card providers and loan providers increase their rates, and with credit card providers it obviously effects existing customers.
How can they justify doing that, why is my APR suddenly going up when I have not done anything?
PH: I suppose there are other factors moving away from just core interest rate. Historically credit card providers have had other income streams, including payment protection insurance, and there’s been a change in legislation which means that they are no longer able to cross-sell that to consumers when they’ve taken out a card. So I suppose credit card providers are thinking ‘how can we boost margins elsewhere?’, so they’re actually determining how increasing rates will do that.
Q7: So they are using higher interest rates as a method of recouping some of the money that they have lost from other streams.
PH: I suppose there is an element of that, as well as the increased risk of that consumers pose.
Q8: Because that is another problem that they are facing isn’t it, because of the financial crisis and people losing there jobs and financially they have over stretched themselves. There is an increasing number of people that have been struggling to keep up with credit card payments and as a result I guess the credit card companies have got higher levels of bad debt and the likes of you and I – the customers who can keep up with payments, are paying for it aren’t they in the way of higher interest rates?
PH: Yes. One of the key things that’s happening at the moment is that you’ve got an increasing number of people defaulting on credit, and that doesn’t apply to everyone, but you’ve also got those who are using credit cards to spend on their day to day costs, maybe their shopping, but also using credit cards to pay off mortgages, which is usually a risk as a short term lending solution.
Q9: Ok, so what can people do? If you are annoyed that your interest rate has gone up significantly by your card provider, what can you do?
PH: I think it’s essential that you actually determine what interest rate you’re paying, and if you’re not happy with that then do look for a new credit card- there are plenty of deals out there still in terms of loads of 0% deals, and I suppose also some long-term standard rates as well, which are fixed. So it’s important to evaluate the decision and if you’re not happy then do look to switch elsewhere.
CF: Assuming your credit rating isn’t to bad you probably can get a better deal elsewhere!
PH: You can, as I said it’s a time where it’s only worth applying elsewhere if you have an excellent credit rating.
CF: Right ok, thanks Pete
PH: Thank you