How risk-based pricing affects your loan pricing

The Central Bank of Kenya (CBK) has been pushing for a risk-based pricing framework to be adopted by the banking sector. As a result, commercial banks can now factor in a borrower’s creditworthiness when applying for a new loan, loan top-ups, and during loan restructures.

As of October this year, at least 22 of the 38 commercial banks have cleared their risk-based management models by the regulator.

Central banks seek to have a uniform approach to fees and commissions charged during loan processing to standardize the cost of obtaining credit for individual and business loans; this move has faced backlash from the banking sector as this will hurt their profitability.

Risk-based pricing occurs when lenders offer different categories of borrowers, differential interest rates, and other loan terms based on their estimated risk portfolios.

Loan pricing on Annual Rate-APR

For personal secured loans, the average Annual Percentage Rate (APR) for the top 5 most expensive banks is 19.1%, with the average annual interest rate coming in at 14.5%. For personal unsecured loans, the average APR for the five most expensive banks is 24.8%, with the average annual interest rate coming in at 13.8%.

For mortgages, the average APR for the tier 1banks is 28.0%, with the average annual interest rate at 14.3%.

On average, the annual interest rate for tier 1 banks is 13.8% – 14.5% for the various categories of loans offered.

This is approximately 7.0% points higher than South Africa’s average annual rate, which stands at 7.5% and 11.2% higher than USA’s 3.3%. However, Kenya’s average annual interest rate is 6.5% lower than Ghana’s average lending rate of 21.0%.

According to CBK, the private sector credit growth declined in 2021, coming in at an average of 7.8%, compared to the 8.0% recorded in 2020, partly due to the cautious lending strategy adopted by banks during the COVID-19 operating environment.

The most common options include mobile money, banks, informal groups, insurance, digital apps, and microfinance institutions.

According to the 2021 FinAccess Report, mobile money was the most used financial platform accounting for 81.4% of users, followed by banking institutions at 44.1%, then informal groups at 28.7%. However, the usage of digital loan apps declined to 2.1% in 2021, from 8.3% in 2019, mainly due to increased competition from bank-based product innovations and non-listing borrowers to the Credit Reference Bureaus (CRBs).

The impact of the CRB freeze on current lending

The directive by CBK to freeze default status for loans for one year led commercial Banks to heavily cut back on lending to individuals and small businesses whose risk profiles and creditworthiness could not be determined.

Risk-based pricing allows lenders to set prices according to risk exposure. If a borrower is considered risky, the risk-based pricing framework will have them pay higher interest rate rates, fees, and commissions, resulting in a higher total cost of credit.

Lenders look at a variety of factors when evaluating risk. Of course, your credit history is an integral part of any risk-based pricing decision.

Lenders may look at many additional elements, such as loan-to-value (LTV) ratios, debt-to-income ratios, and other factors related to a borrower’s overall financial picture and current obligations. These will affect the ability to pay back the loan in case of default.

On the other hand, risk-based pricing gives people an opportunity they otherwise would not have had. Instead of being denied, they’re told, “you can borrow, but it’ll cost you.” If everybody knows how the system works, it seems fair enough.

Regulators want to ensure borrowers understand when they pay more under risk-based pricing, so they now require lenders to notify borrowers who pay higher prices.

It’s important to note that Risk-Based Pricing must be based on objective measures such as credit score, income, and employment and not on prohibited bases like age, race, and religion.

A borrower should be presented with the Risk-Based Pricing notice if it were based on their credit score, which helps you understand what the perceived risk is and how it’s affecting pricing. The borrower would be under no obligation to accept the loan terms if they disagree with the offer.

By Mercy Nehema

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