Risk Based Lending is a tiered pricing model used to assign loan amounts, rates, and fees based upon borrower’s ability to repay within each tier level. Most lenders have their own methodology to determine each tier, using such factors as credit score, debt to income, job history, among other repayment indicators.
Those tiers that have a higher likelihood of defaulting on their loans will be charged more by the lender to extend credit. In contrast those tiers that show a lower risk of defaulting will generally be charged a lower amount.
Establishing an efficient Risk Based Lending system is no easy task. Many lenders are concerned with regulatory compliance, increased loan portfolio risk, increased loan reserves, low loan volumes, and low interest margins. Some laws such as ECOA restrict certain items from being used in establishing tiers. As stated by the CFPB:
Lenders may NOT use certain legally prohibited factors to come up with their risk-based pricing. The Equal Credit Opportunity Act makes it illegal for a creditor such as a lender or dealer to discriminate in any credit transaction, including auto loans, against any applicant because of:
- National origin
- Sex (Gender)
- Marital status
- Age (if the applicant is old enough to enter into a contract)
- Receipt of income from any public assistance program
- Exercising in good faith a right under the Consumer Credit
- Protection Act, which includes consumer protection statutes relating to credit
With all of the laws surrounding equal opportunity lending and the complicated nature of establishing tiers many lenders avoid those tiers with higher risk. The problem with this approach is that many of the riskiest loans can also be the most profitable.
At Visible Equity’s 2014 Analytics Conference, Scott Adkins CEO of SECUWA gave a fantastic presentation on a risk based lending model he recommends financial institutions adopt to stop avoiding riskier loans and establish a well balanced loan portfolio.
In this presentation Scott covered:
- Myths of Risk Based Lending
- Best Practices
- Common Statistical Methodology
- Questions You Should be Asking
Scott has kindly give us permission to share his presentation.