Rate-for-risk financing, which sets interest rates according to a car buyer’s risk factors, is an approach that chimes with the City regulator’s current thinking about fair outcomes for customers, writes Richard Sunman, director of Auto Marketplace at Experian.

We are witnessing the automotive finance market entering a new era. The widespread practice of a dealership charging every car finance customer the same rate of interest is dying out and, although it may be simple, it’s becoming risky and uncompetitive in today’s fast-changing marketplace. 

Rate-for-risk financing

In fact, recent research shows that 92% of customers need finance packages to buy – in which rate-for-risk finance is able to provide finance in a way that provides both a good customer experience and increases the efficiency of sales time.

With rate-for-risk financing, the interest rate charged changes in line with the risk the car buyer poses. It’s an approach that they increasingly expect, as it’s available for most other types of credit such as credit cards and personal loans. And that’s why it’s the one that forward-thinking businesses are moving to at pace.

From growing competition in the automotive finance market to savvy customers and price consciousness, many variables are driving the move to rate for risk. Here’s a more detailed look at these drivers:

The fairer finance agenda

With The Financial Conduct Authority’s (FCA) Treating Customer Fairly agenda – and its new Customer Duty – there is a demand that consumers get fair outcomes in car finance. Rate-for-risk financing clearly shows the regulator that a dealer, broker and manufacturer are aligned with these principles.

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By adopting rate-for-risk financing, lenders can ensure that consumers get fair and justifiable terms that reflect what they can truly afford – therefore clearly showing that a lender is meeting the requirements of the FCA’s Customer Duty guidelines.

A revolution in customer expectations 

We are seeing consumers increasingly demand a personalised buying experience – and are less prepared to accept the ‘one size fits all’ approach to automotive finance.

When considering other credit products, they can check their eligibility and browse the rates they’d get before they apply, without a hard credit check which would appear on their credit report. They have the same expectation regarding automotive finance, with many consumers now desiring the same experience when they apply for a loan to buy a car.

Customers getting more price savvy 

Rising living costs mean that increasingly money-conscious consumers have less to spend. Not only are consumers becoming more aware and informed about the options available to them, but they also expect well-priced, convenient, personalised financing options.

Lenders will need to work harder and smarter to maintain market share. Experian research found that 46% of them expect the cost-of-living crisis to have a ‘significant’ impact on their business, and rate-for-risk provides a way of offering hard-pressed customers a more attractive deal.

Growing competition in automotive finance 

When consumers can shop around for finance more easily than ever before, and channels for buying and selling cars evolve rapidly, offering flat rates undermines competitiveness. With buyers already having the option of using direct-to-consumer finance options with compellingly low rates – more of these products are likely to appear in the coming year, including personal contract purchase (PCP) and personal contract hire (PCH), and are likely to become easier to access.

Less appetite for flat rates among lenders

Flat rates are risky for lenders, as they have no control over the mix of customers who end up in their portfolios. What might be the correct flat rate one month, could be wrong the next if the mix of customers being proposed changes significantly or the cost of lending increases.

Because there is no flexibility in interest rates, organisations can’t accurately price their products to reflect the risk. Consequently, we are seeing a decline in lenders’ appetite for flat rates.

Responding to changes in the economy and its impact on consumer affordability

Rapid fluctuations in the fortunes of the UK economy have put pressure on people’s personal finances and emphasised the need for lenders to look again at the tools and data being used to understand an individual’s affordability. 

The increased regulatory focus on demonstrating firms are putting customers first and are focused on driving the best outcomes means that getting an assessment of an individual’s eligibility and capacity to afford a car when they first apply for a loan is more important than ever before.

The automotive industry is shifting, therefore lenders need to stay up to date with the latest trends and make the necessary changes. By getting a better understanding of the current market, lenders can make better, more informed decisions.

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