The concept of risk-based pricing takes on many different forms for lenders. A financial institution may adjust rates based on either competition or the Fed. However, true risk-based pricing should use a combination of many factors. Some lenders use credit score, term or vehicle, as well as paying attention to other aspects that contribute more to their downside. Accurately pricing risk ensures the long-term viability of an institution’s ability to withstand the unpredictability of the economy and provide an advantage over competition that may not be using a risk-based pricing model.
Lenders can generate higher yields on non-prime auto loans if loans are individually priced to include all costs involved in granting, funding and servicing the loan, along with the projected risk factors that could affect the loan. Non-prime borrowers tend to focus more on payment affordability and simply receiving an approval compared to a prime borrower’s focus on interest rate. Therefore, an effective risk-based pricing model can provide just that.
These factors are generally the standard when determining interest rates:
- Cost of funds
- Servicing and collections costs
- Repossession/disposition costs
- Dealer compensation
Lenders should also consider these additional factors when building a true risk-based pricing model:
- Frequency of default: Loans default at different speeds, not only by credit score, but with loan-to-value ratios, terms and even credit depth.
- Frequency of prepayments: How long loans stay on the books also determines the yield of the institution. Properly priced loans will have a longer average life than using one rate to price a wide range of risks.
- Projected dollar loss if default occurs (loss severity): Potential charge-offs look vastly different based on their timing. A new vehicle loan defaulting in the first year has a much greater loss severity than used cars defaulting in the second year.
- Loan-to-value ratio at origination: Lending to a consumer who puts 20 percent down is a much lower risk than those who need 100 percent financing. By pricing consumers with less skin in the game appropriately, you can still capture the loan but also account for the higher potential loss in the event of default.
- Borrower credit depth (thin, normal and thick files): A credit score with two tradelines and two years of history does not carry the same risk as a credit score with 12 trade lines and 10 years of history.
- Depreciation speeds by make and model: The potential resale value of that repossession varies greatly by make and model. Knowing the vehicles values that hold better will limit the potential severity of charge-offs.
- Direct versus indirect channels (indirect loans are inherently riskier): Application origin should also be factored into a true risk-based pricing model. Default rates and pre-payment speeds are vastly different from one to the other.
By building an auto portfolio whereby each loan is priced appropriately for risk, the overall net yields are much higher than prime portfolios and loan volume increases without having to cut interest rates to the bone.
Risk-based pricing is not a glamourous topic, but is extremely important to building a profitable auto loan program that can be reliable and competitive. In doing so, lenders also position themselves as leaders in their markets for their ability to accurately price loans ahead of their competition.
Open Lending has designed a unique non-prime lending program called Lenders Protection that utilizes the pricing methods outlined in this article. Lenders Protection seamlessly integrates with CRIF Lending Solutions loan origination technology. For over 17 years, Lenders Protection has enabled institutions to safely expand their non-prime lending with higher returns and less risk. The average charge-off is reduced by 85 percent with this solution.
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Matt Roe is SVP of Sales for Open Lending and Lenders Protection. This article is written by Matt Roe of Open Lending LLC and represents the thoughts and positions of the author. CRIF Corporation is publishing this article with the permission of the author and Open Lending LLC.
Photo Credit: GotCredit