APRIL 2006 :: CONSUMER ED

The Smart Money
Businesses Judge You Based on Risk, and Treat You Accordingly

By Karen Blumenthal
Staff Reporter of The Wall Street Journal

When the poker players on cable television have just a so-so hand, there's always that point where they have to make the big decision. Do they bet big and try to bluff their opponents into thinking they have a great hand? Or do they back off and maybe fold?

At that moment, they're facing a classic financial decision: To get big rewards, you often have to take a big risk. You have to push the pile of chips into the middle of the table-and risk losing it all-to have the chance to win big.

There are all kinds of similar examples in investing. To make big money in the stock market, you might gamble on a hot, fast-growing company that may already be highly priced, or take a chance on a company that needs to turn around its business. Both could pay off, or disappoint.

Interestingly, while you're balancing your own risks and returns, companies that you want to do business with are often looking at you with the same trade-off in mind. Throughout your life, they are going to assess how chancy you are, and that will determine how generously they treat you. When they take big risks, they expect big rewards.

Here are a few of the areas where businesses look at you as a risk in determining how they treat you.

INSURANCE. The difference in what adults and teenagers pay for auto insurance is enormous, largely because their driving records are different. Insurance companies gather enormous amounts of data about drivers, accidents and damage to vehicles and use that information to assess risk and set their rates accordingly.

In Dallas, for instance, a 16-year-old boy will pay 3.5 times more for insurance than an adult. A girl the same age will pay 2.75 times more. The girl's rate will fall to an adult's rate when she turns 21, while a young man's rate won't drop until he turns 25. "Young drivers have more accidents and more severe accidents," says Richard Ramirez, a Dallas agent for State Farm Insurance, and boys have more than girls. Getting a ticket may increase your premium because it reflects riskier behavior.

There is a chance for some relief, though: Students with a "B" average or better at the beginning of their junior year can get a 10% discount. "We've learned that kids who are more serious students have fewer accidents," Mr. Ramirez says.

When it comes to life insurance, the tables are turned, and older folks pay the higher rates. "We don't know who's going to die, but we know how many will die" based on statistics on life expectancy, Mr. Ramirez says.

As a result, a 25-year-old will pay $17 a month for $100,000 of term life insurance. A 45-year-old will pay $28 a month, and a 65-year-old will pay $160 a month for the same insurance. When the life insurer agrees to take on a bigger risk with an older person-or a smoker or a skydiver-it expects a bigger reward.

LOANS. If you were to lend money to someone you didn't trust much, you'd want to be paid a hefty interest rate for taking the chance that you won't be repaid. Companies that lend money feel the same way. Before they lend, they judge how trustworthy you are.

Consider the "payday loan," the riskiest kind of loan for the lender. With a payday loan, a customer writes a check to a loan company and gets a quick cash advance in return, with the understanding that the check won't be cashed until after the customer's payday. Lending to someone who has trouble making it from paycheck to paycheck is considered a high-risk business, so payday lenders demand big rewards. They might charge $15 in interest and fees on a $100 loan-a 15% cost for, say, a week's worth of credit. On an annual basis, that's an interest rate of nearly 800%.

To qualify for a lower-cost loan, you'll probably need an established credit record, something you can start building now by opening a bank account or getting a credit card in college.

A typical lender for, say, a car or house will want to know about your income, your employment history and your credit record, which contains information about outstanding debts, the types of loans you have and your payment history. If you've taken out loans before or run up charges on a credit card, your potential lender first will want to know if you paid your bills on time. If you didn't, the lender will tighten the terms of the loan to reflect the increased risk of lending to you. Normally, the worse your credit history is, the costlier your loan will be.

For example, a home buyer with a top-notch credit record could put just 3% down and line up a 30-year, $100,000 mortgage loan with an interest rate of about 6.25%. The monthly payment would be about $600.

But a person with a poor record will end up with a "subprime" loan, which typically means stricter terms and higher interest rates. Because a higher-risk customer won't qualify for the all-in-one, low-down-payment loan. For the same home purchase, he may pay closer to $700 a month, plus $1,000 in upfront fees.

That might not sound so bad-just $100 extra per month. But there's a catch: That initial interest rate will jump up after two years, to 10% or higher from an initial teaser rate of 6.5%. Then the borrower would be looking at monthly payment of about $900, 50% more than the low-risk borrower.

EMPLOYMENT. Some employers will check your credit before they hire you, figuring that how you handle money reflects on how responsible you'll be as an employee. But even if they don't go to that trouble, they will hire you and pay you based, at least in part, on how committed you are to the work.

One thing employers don't like is turnover. When employees come and go too often or fail to perform, companies become unstable and have to spend money training new workers. So employers prefer to have better-qualified workers whom they can trust to stick around and do the job right. Because those workers pose the least risk to the company, they get the most generous terms: longer contracts or higher salaries. Similarly, when an employer takes a chance on a less-experienced employee-such as a young person straight out of school-it seeks to balance that risk by paying the worker less. The reward for the employer: cheaper labor.

That's why, if you've decided what you want to do for a living, it pays to start building knowledge and skills in the business as early as you can. By doing so, you'll have a head start over other applicants and a chance at a higher paycheck based on your experience.

When you minimize the employer's risk, you reap the rewards.