How does risk based loan pricing work to set interest rates?

In another article we describe how we calculate interest payments on a loan. But we don't discuss where the interest rate comes from. The interest rate is an important aspect to a loan for borrowers and lender alike. Therefore this post explains how we set interest rates on Bitbond.

Interest rate setting mechanisms

The interest rate is the price of money. In free markets prices are set by supply and demand. Beyond finding the price purely based on supply and demand there are other interesting options. Specifically there are 3 different mechanisms by which the interest rates on peer-to-peer lending platforms are set. We outline them all and then show which one we picked for Bitbond and why.

1. The platform sets the rate

In the first mechanisms the p2p lending platform sets the interest rate. That way neither borrowers nor lenders need to spend time on determining the rate. They are faced with a take-it-or-leave-it offer and only need to decide if they accept the rate or not. If the platform chooses to set the rates, they need to come up with an own way of where the rate should come from.

There are multiple ways for the platform to set the rate. Some are rather simple, other ways are more sophisticated. The main options are:

  • every borrower pays the same rate
  • the interest rates are the same on a per borrower basis but vary across different loan maturities
  • the interest rate depends on factors that are related to the borrower’s creditworthiness
  • the interest rate depends on the loan purpose and the borrower’s creditworthiness

2. The borrower sets the rate

The second mechanism lets borrowers offer a certain interest rate they are willing to pay. In this version borrowers need to come up with a way of how to determine their own rate. Lenders are given a take-it-or-leave-it offer and only decide whether they want to contribute to a loan or not.

Typically borrowers will compare themselves with others. Borrowers want to increase their likelihood to get funded. Therefore they will try to offer a rate that maximizes their funding probability.

3. An auction sets the rate

A peer-to-peer lending platform is a marketplace for loans. Just like eBay is a marketplace for goods and services. Since the prices on eBay are determined through an auction, the same mechanism could be applied to loan pricing. Auctions are very efficient pricing mechanisms after all.

There are two options for an auction. An auction where the price increases with every bid (an English auction) and one where the price decreases with every bid (a Dutch auction). In most cases where p2p lending platforms apply an auction mechanism to determine interest rates they use a Dutch auction.

Typically borrowers would set a starting rate which is the maximum they are willing to accept. Then lenders place bids on the interest rate. When the loan receives sufficient funding, those lenders who bid the lowest rates get to invest in the loan. If an English auction was used, the interest rate might end up being so high that the borrower wouldn’t be able to accept it. That’s why  Dutch auctions are usually used.

How risk based loan pricing at Bitbond works

At Bitbond we decided to go with mechanism number 1. We are setting interest rates according to the borrower’s creditworthiness and the duration of the loan. In our view this mechanism has various advantages compared to the other two mechanisms.

When borrowers apply to get verified we estimate their creditworthiness based on comparable data we already have. Since we have detailed data about each borrower and loan, we recognize patterns of good borrowers and not so good borrowers. Those borrowers who tend to represent a higher repayment risk also need to pay higher interest rates. This concept is called risk based loan pricing.

If lenders have a diverse portfolio of loans, their average return should come out at about 10%. We can only make this promise, if we know the repayment risk of loans and if we set the interest rates in the various rating categories accordingly.

Therefore the interest rate setting is a two step process:

  1. Calculate the average repayment rate of each rating category
  2. Set the interest in a rating category so that it matches the promised rate

We can only do this, because we have an overview of all repayment statistics. Individual lenders and borrowers would not be able to do that. If users were to set the price on loans themselves, just from the pure fact that their statistical insights are much smaller than those of the platform, they would always reach an inferior outcome.

We as a platform would need to disclose all personal details we get from borrowers to enable lenders to do the same kinds of calculations that we do. This is something that is not really desirable.

Why Bitbond applies risk based loan pricing

In the paragraph above we discussed how we proceed in setting the interest rate. Now let’s have a quick look on why exactly the other two possible mechanisms in our view don’t work as well.

Why not let borrowers set the rate

As stated above, borrowers want to maximize their funding probability. They can only do that when they have sufficient data on which loans actually get funded at which rates. At the current stage borrowers don’t have access to sufficient data. But even if they did, the evaluation is a time consuming process. It is more realistic that most borrowers would compare a handful of loans and then offer a rate that they can afford.

Why not apply auctions

Auctions on eBay are especially efficient because most people have private valuations about the goods being auctioned off. An antique chair has a different value to most persons because tastes and preferences about furniture differ widely. Therefore different people are willing to pay different prices. In an auction the highest valuation is found out efficiently. The person who values the chair the most will get it and the seller is well off because they received the best achievable price.

Typically loans have common valuations because most lenders are mainly interested in their returns. The value (i.e. the interest rate) of a loan is the same to every lender. If the interest rate is determined in an auction the Winner’s Curse occurs. In every portfolio there is a number of defaulting loans. When interest rates are too low on average, the portfolio return could become negative. This is exactly what happens most loans are underpriced to to the Dutch auction mechanism.

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