Should Lending Companies Shift To A Dynamic Loan Pricing Model? 💰
The use of dynamic pricing is rapidly increasing. As a result of the highly competitive interest rate environment and inflation, even lending institutions are improving their capabilities in order to make dynamic pricing a more suitable loan pricing model for their business.
The problem is, though, implementing dynamic pricing for loans can be challenging for many financial institutions. When determining interest rates, many factors are typically considered, and getting the right teams and software to have efficient pricing mechanisms should be a top priority.
In this article, we are going to discuss dynamic loan pricing model. We weigh its pros and cons. Then, we suggest effective ways lending companies can use it for better transactions and profitability. Finally, we present a case study about October, the lending platform that recently introduced its new dynamic loan pricing strategy.
We argue that lending companies can use dynamic pricing as an opportunity to become more customer-focused and improve their commercial capabilities. At Taylor Wells, we believe that the best loan pricing model values the benefit of both the lender and the borrower. By the end, you will know if dynamic pricing is really a good idea for financial loans.
What Is The Best Loan Pricing Model For Lenders?
The process by which lending institutions determine the interest rate for granting a loan to creditors, whether individuals or businesses, is referred to as loan pricing. It is one of the most vital, but complicated, functions in lending funds to businesses and other customers. Why is this the case? Because it is always hard to pinpoint exactly what the actual loan risk of a specific loan application is.
In a broad sense, the lender seeks to charge a high enough interest rate to ensure that the loan is profitable while also providing adequate compensation for the default risk. Contrastingly, loan prices must also be set low enough so that customers have an easy time paying back the loan.
What are the most common loan pricing strategies?
1. Cost-plus loan pricing model
Cost-plus pricing is the most basic method used by some lending institutions. In general, this strategy assumes that the interest rate charged on any loan is determined by four factors.
The first is the funding cost to raise funds for lending. This is true for funds generated from customer deposits or different money markets. The second factor is the loan’s administration costs. This includes application and payment processing fees, as well as the organisation’s wages, salaries, and occupancy costs. The third factor is a risk premium, which compensates the company for the risk in the loan request. The last factor is the profit margin on each loan which provides an appropriate return on capital to the lending institution.
2. Price-leadership loan pricing model
The simple cost-plus method of loan pricing has major disadvantages. It somehow implies that a lending company can price a loan without regard for the competition from other lenders — which is not really the case. The truth is that competition has an impact on a company’s targeted profit margins.
At the moment, tough competition can significantly reduce profit margins for all lenders. This is why some companies chose a different approach, instituting the cost of credit. The method is called price leadership strategy. For instance, the interest rate charged to the most creditworthy customers on short-term working capital loans is set up as the prime or base rate. The prime rate is significant because it serves as a guideline for other types of loans the company offers.
3. Risk-based loan pricing model
A loan’s risk varies depending on its attributes and the borrower. Consequently, one of the most difficult parts of loan pricing is determining a risk or default premium. Today, there are numerous risk-adjustment methods in use. Credit-scoring systems, for example, are used to assess prospective borrowers and underwrite all types of credit.
Both the lender and the borrower benefit from this strategy. Borrowers with good credit records are rewarded for their prudent financial behaviour because the lending company determines a sensible default premium based on past credit history. Using risk-based pricing, a borrower with better credit will pay a lower interest rate on a loan as a result of the company’s anticipation of lower losses. This approach also fosters trust in the lender and ensures loan profits.
Discussion On Dynamic Loan Pricing Model
Aside from the common loan pricing strategies above, a new pricing trend emerges in the form of dynamic pricing. And it is only natural for business managers to investigate. Why is it gaining popularity? Can your company benefit from it as well? Not every trend is appropriate for every business. This includes dynamic loan pricing. Let’s take a closer look at this method to see if it’s right for you.
Dynamic pricing methods for loans?
Financial firms are transitioning from traditional pricing models to more dynamic risk-based pricing for a variety of their products, including loans. Lenders are now turning to machine learning and predictive analysis instead of old established rules and computations to determine risk-based loan pricing and terms premised on credit profile and creditworthiness.
Dynamic pricing for loans works in the same way that it does in other industries by offering up different prices to different customers or segments. One example is the lending platform called October. The company has already introduced its new dynamic loan pricing strategy. We will discuss and assess their approach as we move forward.
What are the advantages of using dynamic pricing for loans?
According to some analysts, dynamic pricing can greatly benefit lending companies because it has the potential to become the foundation of customer lifetime value. This is because when dynamic pricing is implemented for loans, the factors that determine prices will be based in part on customer behaviour. Customers who pay on time, for example, will be rewarded with lower interest rates.
Furthermore, as the company collects more data on borrowers, it will learn more about its customers’ needs and adjust its offers accordingly. Dynamic loan pricing ultimately reduces competition. Because price determinants are no longer based on general market factors but are tailored to each customer or segment.
What are the disadvantages of using dynamic pricing for loans?
Some financial industry experts, on the other hand, believe that genuine dynamic pricing for loans is unattainable. They argue that due to price elasticity constraints, a bank, for example, cannot truly utilise dynamic pricing on a product such as a loan. It will be too impractical and even if they try, it’s too much work. The same can be said for other types of lenders, though due to the lower level of regulatory surveillance, they may have more flexibility.
Regardless of these drawbacks, if lending companies truly want to implement a dynamic loan pricing model, they must ensure that they have the necessary software and quality data to serve as the foundation of their execution. And of course, capable decision-makers must be in charge.
Implications Of A Dynamic Loan Pricing Model
Dynamic pricing requires a shift in focus from products, or the loan itself, to customer valuing and internal growth. Here’s how to price a loan with this strategy:
1. Make certain that you have high-quality data to use as the foundation for your analysis and judgements.
Risk-aversion policies must strengthen loan pricing strategies. With data, companies can predict trends, identify opportunities, and stay ahead of the competition by providing insights into customer behaviour or market conditions before they occur. Data is critical to the growth and success of any business. Managers must make informed decisions based on verified information rather than gut feelings, especially when dealing with financial products and services, such as loans.
2. Utilise software technologies for advanced dynamic pricing decision-making.
There are numerous pricing solutions available, all of which work in comparable but different ways. Not all options will be perfectly tailored to your business model, nor will they be suitable for dynamic loan pricing. Make certain that the software you choose is compatible with your business model and objectives. Also, take into account that your software should be compatible with your entire organisational structure and culture. Thus, proper training may be required to get them used to new technologies.
Investing on commercial capability will be a great help. With our experience with various businesses in different industries, we have seen that when managers build and embeds commercial capability across the business; bolstering its internal pricing skills and capabilities to build a sustainable pricing system, it can generate at least 3-10% additional margin each year while protectibusinessesng hard-earned revenue and volume. This is at least a 30-60% profit improvement straight to the bottom line.
3. Put the right people in charge.
Establish a specialised pricing team. Our findings show that with the right set-up and pricing team in place, incremental earnings gains can begin to occur in less than 12 weeks. After 6 months, the team can capture at least 1.0-3.25% more margin using better price management processes. After 9-12 months, businesses often generate between 7-11% additional margin each year. As they identify more complex and previously unrealised opportunities, efficiencies, and risks.
Case Study On October’s Dynamic Loan Pricing Model
The lending platform, October, has recently employed a dedicated pricing committee as they embrace a more dynamic loan pricing model. According to the most recent October update, interest is the cost of borrowing money for a borrower as well as the compensation for lending money to a lender. This makes sense because they act as a bridge between borrowers and lenders, so they must meet the needs of both parties.
With dynamic pricing, the interest rate that October charges to borrowers, or pricing, is determined by several variables such as the company’s credit score, the risk-free return in a company’s country of origin, the type of analysis applied, the level of security, and the duration of the loan. The pricing committee will examine the relative risk-free interest rate per country on a monthly basis and propose new pricing for all countries or for a specific country.
With this approach, the company can be more adaptable to the changing financial environment. They can also continue to make favourable terms for borrowers and lenders, especially when central bank rates rise or fall. Dynamic loan and interest pricing model not only maximise their profits but also offer a good value proposition to borrowers and lenders.
Financial service prices take into account operating costs, profit margins, and demand. At its foundation, financial service or product pricing is primarily based on risk. Risk assumptions are typically used to price loans. The transition to dynamic pricing and the integration of new technologies that it entails will be a challenging journey. However, the advantages and opportunities for continuous business development make it worthwhile to give it a chance.
October made a wise decision by concentrating on pricing and experimenting with new pricing methods. It is commendable that they established a specialised pricing team to review and improve their pricing capabilities on a regular basis as part of their initiative to implement dynamic pricing. Not only should lending institutions follow this example, but every company can benefit from pricing development as it builds sustainability and growth that benefits both the company and its customers.
For a comprehensive view and marketing research on integrating a high-performing capability team in your company, Download a complimentary whitepaper on A Capability Framework For Pricing Teams.
Are you a business in need of help to align your pricing strategy, people and operations to deliver an immediate impact on profit?
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