Consumer Credit Markets and Loan Pricing: The Basics
October 3, 2018
Consumer Credit Markets and Loan Pricing: The Basics
Congress has demonstrated an ongoing interest in consumer
rate. Given that U.S. Treasuries have never defaulted (nor
credit markets. This In-Focus provides an overview of
do they prepay), Treasury yields or rates are considered
consumer lending markets, pricing, and legislative efforts
“risk-free.” Hence, the slope of the yield curve (shown in
designed to facilitate efficient credit allocation and pricing.
Figure 1) consists of the rates of return that lenders could
receive by lending to the U.S. Treasury (i.e., purchasing
Consumer Credit Markets: Introduction
U.S. Treasury bonds) at different maturities. Lenders
Credit allows consumers to make purchases today rather
require compensation from consumer loans to be at least as
than postpone them until some point in the future, thus
high as the risk-free lending rate; otherwise, they would
avoiding the need to save sufficient amounts of funds to
simply purchase risk-free Treasuries. Consequently, the
make payments in full. The consumer credit (loan) markets
base rates for loans are generally set to comparable yield
consist of multiple products with numerous market prices.
curve loan maturities. For example, the base rate of a 5-year
Consumer credit may be in the form of mortgages,
consumer loan is likely to begin with the current rate of a 5-
revolving credit cards, automobile loans, personal loans,
year U.S. Treasury rate. (The base rate for a 30-year
and student loans. Consumers may obtain loans from
mortgage loan, however, may begin with the 10-year
depository institutions (i.e., banks and credit unions) and
Treasury rate because many mortgage loans are usually
non-depository institutions (e.g., payday lenders, finance
repaid or refinanced in 10 years.)
companies). Lenders generally underwrite loans, meaning
that they evaluate loan applicants’ credit risk by considering
Figure 1. Upward-Sloping U.S. Treasury Yield Curve
factors such as their income and repayment histories of past
loans. (Some non-depository lenders, however, make
higher-priced consumer loans without formal underwriting.)
When a loan default occurs, the contract provisions
negotiated by the lender and a third-party loan servicer
(who collects payments from borrowers, administers
disbursements to the lender and, if necessary, to escrow
accounts, insurance providers, etc.), in conjunction with
relevant laws, determine (1) whether the servicer can offer
loss mitigation solutions and, if so, what types and with
what limitations; and (2) when the servicer can begin the
formal debt-collection process or initiate foreclosure and, if
so, any rules that must be followed and allowable actions.
Servicing rules are designed to minimize the costs to collect
Next, the initial base rate is risk-adjusted to account for
defaulted obligations, which are primarily borne by the
financial risks that are idiosyncratic to borrowers. Risk-
lender. Lenders may attempt to recover debts by doing their
based pricing is the practice of charging riskier borrowers
own collecting or by hiring contractors to collect the debt
higher rates to reflect their additional default (credit) risk.
on their behalf. The Fair Debt Collection Practices Act
Higher-risk borrowers are likely to pay more for credit
(FDCPA) of 1977 prohibits debt collectors from using
relative to lower-risk borrowers, but risk-based pricing may
abusive, unfair, or deceptive practice while collecting
result in fewer credit denials and greater credit accessibility.
consumer debts. If, however, a lender decides to sell the
In short, borrowers pay different prices for credit products,
debts outright, FDCPA may not apply to debt buyers.
often because they pose varying levels of default risk.
Because resolving defaults can be expensive, these potential
Lenders may also factor in the prepayment risk of
costs are frequently priced into loans.
borrowers, or the likelihood that a borrower pays off a loan
ahead of schedule when market interest rates change.
Loan Pricing Mechanics
Lender profits are principally generated from the difference
Markup Above the Risk-Adjusted Base Rate
between the loan price (interest rate charged to the
The markup above the risk-adjusted base rate consists of
borrower) and the costs incurred by the lender to acquire
additional charges and fees that are generally unrelated to
the funds that will be lent. A loan price may be separated
borrower financial risks.
into two components: the risk-adjusted base rate and the
mark-up, discussed below.
Markups include loan origination costs, such as the costs
to purchase credit reporting data and verify borrowers’
The Base Rate and Risk-Adjusted Base Rate
identities, incomes, and employment.
The determination of the price borrowers will pay for a loan
typically begins with the determination of the risk-free base
Markups include ancillary costs, such as costs to cover
loan servicing.
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Consumer Credit Markets and Loan Pricing: The Basics
Markups may reflect a lack of market competitiveness
The Real Estate Settlement Procedures Act of
or shopping for more favorable loan pricing.
1974 (RESPA; P.L. 93-533) requires lenders,
mortgage brokers, or servicers of home loans to
Markups may include poorly disclosed or even
provide borrowers with pertinent and timely
unobservable factors such as disparate treatment or overt
disclosures regarding the nature and costs of the
discrimination, typically investigated using statistical
real estate settlement process.
analysis in fair lending examinations of financial
institutions. (Sometimes making a clear distinction
The Home Ownership Equity Protection Act of
between the risk-adjusted base rates and the mark-up
1994 (HOEPA; P.L. 103-325) amends TILA to
components is challenging for regulators who conduct
require additional reporting of high-cost refinance
fair lending examinations.)
and other non-purchase loans secured by primary
(owner-occupied) residences.
Consumer Credit Market Access and
Loan Pricing: Some Legislative Actions
The Credit Card Accountability Responsibility and
Congress has passed legislation to prohibit discrimination
Disclosure Act of 2009 (CARD Act,;P.L. 111-24)
and increase access to credit.
restricts pricing practices that may result in hidden
and complex penalty fees and assessments on
The Equal Credit Opportunity Act of 1974
credit card holders.
(ECOA; P.L. 94-239) prohibits creditors from
discriminating against applicants on the basis of
The Dodd-Frank Wall Street Reform and
race, color, religion, national origin, sex, marital
Consumer Protection Act of 2010 (DFA; P.L. 111-
status, age, or because of receiving public
203) contains a number of consumer protection
assistance.
provisions. Examples include the DFA’s
Consumer Financial Protection Bureau (CFPB)
The Home Mortgage Disclosure Act of 1975
established to implement and enforce federal
(HMDA; P.L. 94-200) requires disclosure of
consumer financial laws while ensuring consumers
mortgage origination information. This
access to financial products and services. The DFA
information allows regulators to identify
created the ability-to-repay (ATR) rule, which is
geographical patterns of mortgage originations to
implemented by the CFPB, to establish minimum
determine where further investigation of redlining,
standards that all creditors are required to consider
or geographical discrimination, may be necessary
during the underwriting of U.S. residential
to increase credit access to creditworthy
mortgage loan originations. The DFA gives CFPB
individuals. (In 2002, the Federal Reserve updated
regulatory authority over banking and nonbanking
Regulation C, which implements HMDA, to
firms that offer consumer financial products. The
require the rate spread reporting for higher-priced
CFPB has since implemented or proposed rules
loans to discourage discriminatory loan mark-up
pertaining to small-dollar lending products, which
pricing practices.)
may influence their markup and availability. See
CRS Report R44868, Short-Term, Small-Dollar
The Community Reinvestment Act of 1977 (CRA;
Lending: Policy Issues and Implications, by Darryl
P.L. 95-128) encourages federally insured banking
E. Getter.
institutions to make sufficient credit available to
creditworthy individuals in the local areas where
The Economic Growth, Regulatory Relief, and
the institutions were chartered and acquired
Consumer Protection Act of 2018 (EGRRCPA;
deposits. For more information, see CRS Report
P.L. 115-174) contains provisions pertaining to
R43661, The Effectiveness of the Community
consumer repayment data, possibly having effects
Reinvestment Act, by Darryl E. Getter.
on some risk-adjusted base rates. EGRRCPA
includes various protections for veterans. The
Congress has also passed legislation concerning (1) loan
EGRRCPA also requires Fannie Mae and Freddie
price transparency and disclosure requirements; and (2) the
Mac to consider the merits of using alternative
reporting of consumer payment history data. These factors
versions of credit scores, which could potentially
may influence the markup sizes above the base loan rates.
benefit individuals with limited or no traditional
credit history. For more information on consumer
The Truth in Lending Act of 1968 (TILA; P.L.90-
repayment data, see CRS Report R44125,
301) applies to all forms of consumer credit. TILA
Consumer Credit Reporting, Scoring, and Selected
requires covered lenders to disclose the total cost
Policy Issues, by Darryl E. Getter.
of credit, which includes the loan rate and fees, in
the form of an annual percentage rate (APR).
Darryl E. Getter, Specialist in Financial Economics
IF10993
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Consumer Credit Markets and Loan Pricing: The Basics
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