Interest rate - Risk-Based Pricing
As a lender, you can either have a product-driven interest rate or choose to take a risk-based approach toward interest rates.
Product-driven interest means that every customer has the same interest rate based on the product that a customer chooses. Profitability for a product is much easier calculated because it is just the average risk costs per loan within the product portfolio.
Risk-based pricing strategy considers the risk of each customer based on the probability of default.
This approach is beneficial to you as a lender because it can be used to differentiate rates and be more profitable and competitive. On the other hand, this approach is difficult to execute because you need to have a good understanding of the risk of each customer.
Risk-Adjusted Return On Capital
Some companies go so far as calculating Risk-Adjusted Return On Capital (RAROC) for each customer and set each customer the interest rate accordingly. RAROC may consider also the Life-Time Value of the customer including potential Cross-/Upsell.
The complexity of risk-based pricing is in the fact that the formulas for calculating RAROC may change and may include multiple models.
The models involved in the RAROC can be
- Antifraud model - the probability of fraud
- Credit risk model - the probability of credit risk
- Cross-/up sell propensity model - the probability of taking up an offer
The complexity also arises due to different customer segmentation on demographics.
Risk-based pricing in its full complexity can be a sub-flow within the underwriting decision flow.