How do lenders decide who to approve and who to decline?

An easy answer could be “they approve everyone they think they can make money on and decline the rest.” But that just begs the question: “How do they decide they can make money on Maria, but not on Mark?”

Let’s start with some basics about lending by talking fruits and vegetables.

A produce stand is in the business of buying fruits and vegetables from farmers, marking up the prices and selling them to you. The produce seller has to charge enough to pay the farmers, the rent, the salaries of her employees and other basic business expenses, and cover the cost of the stuff which doesn’t sell and has to be thrown away.

Lending works in pretty much the same way. Except lenders “buy” money by borrowing it themselves (let’s say from a bank). They then “mark up the price” through an interest rate. The lender has to charge enough interest to pay back the bank, pay their basic business expenses and cover the cost of the loans which don’t pay back and have to be thrown away (in lending we call the loans we throw away “charge-offs”).

Now that we understand the basic lending business model – let’s talk risk (in a greatly oversimplified way just to get some major points across).

Lenders have risk models which assign each application a grade. The grade represents their best estimate of how likely the application if approved and funded, is to default and/or be charged off. So, for purposes of illustration only, let’s imagine a risk model that looks like this:

Lenders will decline every applicant when they can’t figure out the risk and set a price that will cover the expenses and the charge-offs. In the chart above, all Fs will be declined because the credit model can’t tell if they are going to charge off at 25% or 55%. The lender can’t price for those risks.

Lenders will also decline every applicant where, even if they understand the risk, the interest rate they would have to charge to price for the risk (the charge-offs) and their expenses would be too high. The price might be too high based on government regulation, or it might be too high for their internal policies. If the chart above were from a bank with a policy of never charging more than 15% interest on a personal loan – all “E” applicants would be declined and probably all “D” applicants as well. If their basic business expenses were high, even the “C” credit applicants would be declined. Only As and Bs would be approved.

Full disclosure: Mark Lorimer has been a corporate lawyer (currently in recovery), a Public Company CEO, a private investor, and was the CMO at CAN Capital from 2006-2012 (where he also led the teams responsible for Asset Management, Revenue Speed, Collections and Legal Collections). Currently, he serves as the CMO of LendingPoint. All opinions expressed are his and do not reflect the opinions of LendingPoint.