Shopping the Competition: How Much Should
This Influence Auto Loan Pricing?
By Jack Jordan, Open Lending
I learned my first lesson in product pricing when I was working in a grocery store back during
high school. One day the store manager gave me a list of different items from the store shelves
and asked me to drive around town and record the prices of these items at competing grocery
stores. He then used the information I gathered to set his every day and sale prices. I imagine
many of the other grocery stores did the same thing and the result was probably healthy price
competition. But I also realized one other thing about my boss’s pricing strategies: he didn’t
always set the store’s prices to be the lowest in town. He also focused on several other factors
to help the store be profitable: cleanliness, customer service, selection of products, overhead
and spoilage costs.
Later in college I learned that trying to build a competitive business based mainly on price is a
difficult thing to do. The practice can lead to disloyal customers, thin margins and, ultimately, to
high volumes of business activity that is not necessarily profitable. Those who compete based
largely on price had better be prepared to always be the lowest cost provider. Otherwise they
risk losing their competitive edge and business quickly.
When it comes to pricing a more complex product, such as an auto loan that has future risk
factors that will determine its ultimate profitability, how big a role should competitor pricing play?
Is it reasonable to rely heavily on competitor price (rate) shopping and compete mainly on the
basis of interest rate? Based on my experience, many auto lenders are heavily influenced by
competitors’ rates and often there is a perception that a lender cannot attract new loans without
meeting or beating the market’s best rates. But there are risks inherent in relying too heavily on
competitor pricing just as there were in the grocery business.
Traditional marketing texts teach that smart pricing should be based on the “4 C’s of product
pricing,” namely: Customers, Competitors, Costs and Constraints. We also learn that price is
the only marketing tool that directly affects both the top and bottom lines of the P&L statement,
that is, both gross revenue and net profit. Let’s look at the four components of pricing and how
they relate to consumer auto loans:
Customers – Pricing should be based on understanding your buyers (borrowers) and
what they perceive as value (Value = Price + Perception). How sensitive to price are
they likely to be? How do they shop for loans and what factors in the marketplace
influence them most? In auto lending, for example, we know the borrower is heavily
influenced by actions that take place at the dealership. Market intelligence tells us that
prime borrowers are very sensitive to interest rate, whereas non-prime and sub-prime
borrowers are more focused on getting the best vehicle for the lowest payment. These
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kinds of customer insights are very important to pricing strategy and they highlight an
important difference between prime and non-prime loan pricing.
Competitors – This is where knowledge of competitors’ pricing and products comes into
play, and understanding the competition is far more complex than just knowing their
interest rates. What is their reputation in the market and how consistent are their lending
services over time? What special programs or dealer incentives do they offer? How
quickly do they fund loans and pay dealers? What other fees or incentives are involved
in their loan programs? How are their products structured (terms, requirements,
limitations, etc.)? These kinds of competitor attributes are important to understand so
that all the factors that influence business flow are known. It is entirely possible, for
example, to gain market share by serving dealers better and faster. Similarly, creating
loan products that are unusual or offer extended terms, easier underwriting constraints,
or more favorable loan-to-value ratios can lead to increased volume without having to
lower loan rates.
Costs – Pricing strategies should be fully aware of the total costs of delivering a product.
But auto lenders don’t always have a good handle on the real costs of loans that may
vary in their risk characteristics. In our grocery store pricing example, it is not necessary
to price a pound of coffee based on what may happen to it in the future. But with auto
loans, the projected costs down the road are important factors in today’s pricing. The
following is a list of some of the major factors that contribute to the overall costs and
eventual profitability of auto loans:
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Cost of funds that are being loaned
Origination, servicing and overhead costs (labor, buildings, computers, etc.)
Money paid to attract and capture loan opportunities (such as dealer fees or
advertising costs)
Collections, repossession and collateral liquidation costs
Loan losses – much can be said about this category of cost. Loan losses are a
function of the frequency of default (commonly forecasted by borrower credit score or
similar predictors) and the severity of default (how much is lost after a loan defaults
and collateral is liquidated). Frequency of default, as predicted by credit score, can
also vary by borrower credit depth (as with “thin file” borrowers) and by lending
channel (e.g. indirect auto loans, in general, can be more risky than direct auto
loans). Loan loss severity is heavily influenced by whether the collateral is new or
used and by what the loan-to-value ratio is for a particular loan. For example, net
loan losses could easily be higher on an “A paper” prime loan for a new vehicle than
for a “B paper” used auto.
Constraints – this final component of pricing involves and understanding of what internal
and external limitations must be taken into account. This is a mixed bag of factors, such
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as interest rate caps, regulations, availability of resources, inadequate technology, builtin inefficiencies in the business flow, etc.
Understanding a bit about the 4C’s of pricing, is there evidence that automotive lenders today
may be using inadequate and unwise pricing methods? I think there is. First, interest rates for
prime auto loans are extremely low having been driven down through fierce competition, low
cost of funds and from increasing consumer demand following the depths of recession. Net
profit margins are also very low. In turn, the fierce competition for low-rate, low-yield loans has
caused some lenders to increase their appetite for non-prime loans where there is the perceived
opportunity for more volume and higher net yields. But even in the non-prime arena, price
competition is driving loan rates down, perhaps to dangerously low levels for some lenders that
are not fully aware of all the costs and risks involved, including increased loss frequencies,
increased loss severities and higher servicing and collections costs.
A recent national automotive industry publication reports a decline in average rates for “C”
paper from 5.82% to 5.28% between March and September of 2012. The same benchmark
rates are down from 6.15% a year ago. These are some of the largest interest rate declines in
any risk segment. Excessive focus on competitor rates can easily contribute to pricing errors
that erode or eliminate the higher net spreads that lenders would hope to earn on higher risk
loans. The end result of all this could be large volumes of underpriced loans, largely created by
too much emphasis on competitor rate matching and driving loan volume increases solely by
price (rate). The possible benefits of non-prime lending have been negated by low rates, and
the ultimate risk to the lender has been increased.
It is a mistake to think of auto loans, especially non-prime loans, as a monolithic commodity
where the only difference between one loan and other is the price. As we see with the 4 C’s of
pricing, there are opportunities to better understand the customer, the product itself, market
conditions, costs and risks. These help contribute to smart pricing instead of reactive pricing.
In our work at Open Lending, we have put sound pricing strategies to work in a unique nonprime lending program known as the Lenders Protection Program. The value proposition
offered by the Program can be summarized as “More Loans, More Yield, But Not More Risk.”
Here’s how that is accomplished:
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The Program focuses on near-prime loans with special emphasis on longer repayment
terms, higher loan-to-value ratios and reasonable underwriting rules. Instead of chasing
lower interest rates to attract business, the Program is designed to offer a unique
product that will appeal to dealers and consumers alike, especially those with damaged
credit ratings.
The Program serves borrowers who are less sensitive to rate and more interested in
buying a higher quality vehicle at an affordable monthly payment. By offering longer
loan terms, borrowers can afford better vehicles and still have manageable monthly
payments.
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•
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The Program allows lenders to approve a wider spectrum of loans with fewer restrictions
and conditions, and close a higher percentage of their application flow. In many cases,
the lender has already spent time and money processing these applications so efficiency
is increased when more of them end up as closed loans rather than lost opportunities.
The additional risks implied by longer terms, higher LTVs and lower borrower credit
scores are managed through high quality loan default insurance with protects the lender
from the large majority of losses.
A sophisticated pricing model is used to set an appropriate interest rate for each funded
loan. The model is aware of all risks and costs that will, in the end, determine the
profitability of the portfolio of loans. The model accounts for program costs, servicing
and collection costs, repossession costs and uninsured loan losses. It also assesses
risk based on projected defaults, projected default severity (actual dollar losses), loan
channel risks, borrower credit depth and loan prepayments.
By building a portfolio composed of loans where each is priced accurately, the overall
net yields are much higher than prime auto loan portfolios. And loan volumes are
increased without having to cut interest rates to the bone.
The Lenders Protection Program blends all of the important pricing factors into a comprehensive
auto lending program that is effective for both direct and indirect auto lending. It can boost loan
volume and profitability nicely in the indirect channel, especially when lenders couple it with an
effective indirect lending culture and dealer relationship program. The Program is geared to
allow lenders to safely capitalize on the non-prime lending sector where margins can, in fact, be
wider and profit margins higher than on prime loans.
About the author
Jack Jordan has worked in consumer finance since 1981. As a manager at Velocity Credit
Union in Austin, Texas he became involved with indirect auto lending in 1989 when the credit
union became one of the earliest adopters of indirect lending among credit unions nationwide.
In subsequent years, he worked with many prime, non-prime and sub-prime programs in all
aspects of loan origination, risk-based lending and pricing, automated underwriting, risk
management, collections and portfolio sales. Jack is currently VP of Lending Services at Open
Lending, LLC, the exclusive marketer of the Lenders Protection Program to auto lenders
nationwide.
Open Lending
www.openlending.com
888-895-3555
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