Making The Figures Add Up

I got asked a question today about the sub prime motor and thought I would share it here.
The question was along the lines of "How can the finance company know who is going to pay and who isnt going to pay"

Well this is quite interesting because, we don't. What we do know, using our existing data is that if we lend to 100 customers aproximately 20 will not pay. So this raises an interesting question about pricing and rate for risk etc.

In the old days there would be a model for offering a "rate for risk" plan. Oh yes, the concept sounds good - get the people who are higher risk to pay more, however, it is totally flawed. This is because, you only make money if people pay you back (end of). If the higher risk customers dont pay, it makes no difference what "rate for risk" price you made. The other thing is that the customers more likely to pay will be less likely to take the higher rate, therefore making the overall "rate for risk" top heavy with desperate customers who have no intention to pay.

So, then how does it work in practice? Well, in essence its very straight forward. Remember the 80 will pay and the 20 will not?, well the 80 who pay, have to provide enough profit to make up the shortfall from the 20 that dont pay, hence the rates being higher in sub prime lending. Sure you will get some return on repossessions of vehicles of those 20 non payers, however, the cost of collecting on those accounts, sale costs and legal action etc. will swallow much of this up.

Therefore I would ask that for those righteous people who believe that these customers are getting "ripped off" think about it a little more. Heres an analogy, if your wanting to grow 100 tomato plants, you dont plant 100 seeds - you know that some wont make it, so you compensate for that.

i hope this makes things a little more easier to understand