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Written by Jeff Keltner, SVP Business Development
There’s a lot of confusion surrounding credit policies and how they apply to risk-based pricing. But what if banks and credit unions could get rid of the traditional underwriting rules? What would that look like for lenders?
In a world without underwriting rules, lenders would rely on the model to tell them how risky a given obligation is and how to price and approve or decline that credit offer.
The typical application of risk-based pricing
Generally speaking, banks and credit unions view risk-based pricing as responsible for pricing a loan’s interest rate. There are also relatively simplistic, but often harsh, rules or policies around things like approval. These can include minimum credit score or maximum debt-to-income (DTI) ratio requirements.
Lenders may also set a loan maximum. Their underwriting rules might say that if an applicant has a credit score above X and a DTI ratio below Y, they can get approved for that maximum. If the applicant’s DTI ratio is slightly higher, however, they might qualify for a lower maximum loan amount.
In other words, there’s a table and set of rules determining who qualifies and the maximum amount they can receive. More sophisticated modeling techniques then determine the pricing for those loans.
A Look at Underwriting with No Rules
The decision to extend a loan offer often comes with many questions, including
- Who should lenders loan money to?
- How much should they be willing to lend at a maximum?
- How much should they charge borrowers for that amount?
These questions boil down to one larger question — how likely is the applicant to repay their loan obligation?
Underwriting with no rules would involve using more sophisticated models to determine the answer. These models would be able to assess the likelihood of repayment and default based on the applicant’s credit score, DTI ratio, and desired loan amount more precisely and accurately.
Assessing Risk and Determining Loan Pricing without Rules
While the underwriting models are more sophisticated, they’re helping answer the same questions:
- How risky is it to extend this offer to the applicant?
- How should they price that risk?
- Are they comfortable with the risk?
If the lender decides the risk is acceptable, they’ll need to determine the right price. That can vary based on several different variables, such as the applicant’s loan size, credit score, DTI ratio, and more.
In a world without underwriting rules, lenders would rely on the model to tell them how risky a given obligation is and how to price and approve or decline that credit offer. That can empower lenders to approve more applicants and assign more appropriate loan pricing.
Provide Better Lending Solutions to Borrowers
So, would it be possible for lenders to get to a world they get rid of the rules? That would require them to rely on models to judge risk, and they would have to base their decisions on the information provided. The world isn’t there yet, but it’s close.