Posted by Cesar Magnaye :: July 10, 2007 @ 9:51 am

It’s safe to say that we all want our money to earn the highest possible interest rate in the P2P marketplace. How do we know when an interest rate is not right for us or when it is too good for our own good? Is there a framework that can help us answer this question?

Since P2P lending is Web 2.0 retail bank lending minus the bank, let’s look to traditional banking for some ideas. Each bank has its own in-house loan pricing model. However, banks use the following models to determine what interest rate to charge their borrowers:

• Cost-plus Pricing. In this pricing model, the interest rate charged on a loan has four components:
cost of funds (interest cost on deposits or money market borrowings used to fund the loan);
cost of servicing the loan (application and payment processing, wages, salaries and occupancy expense); risk premium (default risk inherent in the loan); and profit margin (adequate return on bank capital).

The latter three items can be bundled into what bankers call a “spread,” expressed as a per annum rate, to simplify its use in the pricing formula. Thus, you can look at a quoted bank lending rate (say, 10% p.a.) as consisting of a cost (say, 6%) plus a certain spread (say, 4%).

• Relationship-based Pricing. Under this approach, a “prime” or base rate is established by the bank for its most creditworthy customers on short-term working capital loans. The prime rate, once established, becomes a benchmark for many other types of loan products of the bank.

To maintain an adequate business return using this approach, a bank adds a spread (as discussed above) when lending to non-prime borrowers, in a way that would keep its funding and operating costs and risk premium as competitive as possible.

• Risk-based Pricing. This pricing scheme is decidedly more complex than the previous two because of the variety of risk-adjustment methods that are currently in use. Most of these are too technical to explain and are not relevant for our purposes here at Lending Club.

Lending Club uses a leading-edge risk-adjustment-based method with a credit-scoring system to set an appropriate default premium when determining a potential borrower’s interest rate.

With risk-based pricing, a borrower with better credit will always get a lower rate, due to the expected lower losses to be incurred from his account. With this pricing method, less risky borrowers do not subsidize the cost of credit for more risky borrowers.

Knowing about the various loan pricing methods, you can better understand how professional bankers price their loans. You can now also approach P2P lending more scientifically than before.

One conclusion you should draw is that on Lending Club, borrowers can receive lower more competitive rates than they would get from banks. Lending Club does not have the large cost structure that banks face.

Another conclusion we can make is that there is no right or wrong method. To take it to the extreme, if you lend money elsewhere you can opt to be totally arbitrary and devoid of any method when deciding on your loan rate.

If you set your loan rate with a willful disregard for credit risk in order to attract or retain borrowers, you will be engaging in an unsafe and unsound lending practice. Instead, lend on Lending Club where you will benefit from the most advanced methods to set a reasonable rate that will allow you to earn money at relatively low risk.