How loans are priced – and why it matters
The auction model
Some platforms will list a loan without specifying an interest rate.
Potential investors are encouraged to take a view on how risky that loan is, and bid at a rate which they think is appropriate. Once all the bids are in, an algorithm takes all the bids and combines the lowest ones to arrange the loan at the lowest possible rate.
The auction model has some advantages:
1. Loans are more likely to fill – even if the prospect is not attractive, investors can set a high rate
2. Borrowers will get the lowest possible rate available at the time
The auction model can be an attractive proposition, and especially so given that investors decide the rate.
Why we don’t use the auction model
We don’t think that the auction model is perfect. The main flaw that we see is that interest rates can be affected by the number of investors on the platform and their experience in assessing risk.
In a perfect market, the cash investors have available is exactly equal to the loans on offer. In this market, all loans are priced correctly as there is no competition between investors to get their cash invested.
However, the market isn’t perfect and there is always an imbalance between the cash investors have and the loans available. Where investor cash is greater, investors will battle to out bid each other at lower rates, just to ensure their cash is invested. This is great for the borrower as their cost is reduced, but is potentially not the best outcome for the investor. Conversely, when investor cash is not sufficient to meet demand, loans are priced higher. Bad for the borrower, better for the investor.
There’s slightly more to it than that though. Some investors are extremely knowledgeable about SME lending, and would be able to accurately price a loan based on risks identified in a credit report. However, with an auction model, there’s a risk that inexperienced investors jump in without understanding the risks and place bids at excessively low rates, or that there would be a battle just to get cash invested regardless of the return.
The upshot of all this is: in some cases, investors might get a lower return for the same risk.
Our alternative: fixed pricing
We don’t think that’s fair. Instead, we use a fixed pricing model. We have a team of lending experts – people with decades of experience in SME and property lending – who determine the rate based on the risk of that loan. Investors are then invited to lend at that rate.
With our model, investors do still have control. We offer a wide variety of loans and risk profiles, which gives investors the opportunity to lend at the risk level they are comfortable with. We also listen to feedback from investors about levels of return they would expect for the risk involved.
So there you have it – that’s why we use a fixed price model: it aims to provide fair, consistent pricing to our investors based on the level of risk involved.
Got another question you’d like answered? Leave us a note in the comments section below and we’ll see what we can do.
Andrew Holgate
MD, Assetz Capital
- August 14, 2014