Underwriting for any loan carries a significant recourse for credit unions. When it comes to credit card underwriting, criteria that is too tight and interest rates that are too high might yield a profitable card portfolio, but it’s difficult to grow such a program and members are a flight risk. On the flip side, loosening criteria and dropping rates add to the portfolio’s risk. Such a misstep can end a program and a career, says credit card expert and owner of TRK Advisors, Tim Kolk.
Credit card underwriting is a process that requires an understanding of the institution’s appetite for both risk and profitability. Those two factors weigh heavily into any risk-based pricing strategy.
“Underwriting is the balancing of risk and reward,” Kolk says. “It’s not minimizing risk. A loss is part of being a credit issuer. It’s the balance of loss and rate that becomes the important part.”
Here, Kolk offers three tips on pricing.
1. Understand Underwriting Policy
The goal in underwriting any kind of loan is to approve as many applicants as possible within a specific risk tolerance. But creating underwriting criteria is more complex than that, given pricing, risk, and profitability variables that change depending on the strategic direction of an institution.
However, Kolk says, front-line card managers are often more familiar with underwriting discipline and skills that strategy.
“They don’t know how underwriting policy comes to be,” Kolk says, “They don’t know how to think about pricing and credit lines as a component of it.”
Underwriting, pricing, marketing, card design, and more — these together form the final card product. They are inter-related. And although these card managers should be involved in controlling underwriting policies, they do need to understand them to support the underwriting and risk managers.
It’s not enough for card managers to rely on automated underwriting, Kolk advises. They should understand why criteria is the way it is.
2. Set Risk Tiers
In risk-based pricing, an institution must act strive to make each tier profitable by itself. But first, an institution must set its tiers.
Many credit unions establish five tiers based on FICO scores. Tiers, then, act as guidelines to determine different credit qualities — from A to E, for example — and acceptable pricing, just one part of a larger comprehensive loan filtering process.
However, Kolk says credit card risk tiers should not match the risk tiers for other risk-priced products. It’s dangerous to assume risk tiers among products are the same.
“The risk of charge-off for a credit card at a 720 FICO score is different from the risk for another product,” he says.
In using FICO scores to set tiers, Kolk advises credit unions to aim toward a high starting point for tier one. When credit unions then calculate the price to satisfy both risk and profitability concerns, they’ll get a lower APR. And the lower the best available rate, the easier it will be to attract members.
3. Estimate The Risk In Each Tier
Credit risk in the credit card portfolio is measured by its charge-off rate. Therefore, to determine the credit risk for each tier, a credit union must estimate or calculate the charge-off rate for each tier. There are two ways to do this.
The first is to use the Odds Chart published by the credit bureaus. The Odds Chart shows, within a specific FICO score range, the charge-off odds within a number of years. There are different Odds Charts depending on an institution’s region and whether the account is new versus legacy.
The second way is to measure internal performance at the various credit score tiers.
“Some credit unions like to look at account-level data without a third-party in the middle,” Kolk says. “That is one of the things that is driving the tide toward in-house processing.”
The next step is to calculate the number of charge-offs per card account as well as total dollar amount charged-off for the previous two years and divide the balance in each tier by two — which gives an average amount per year. Refer to member credit scores from two years ago as well in making this calculation.
“Go back two years because the numbers can bounce around,” Kolk advises.
Next, calculate the average balance of accounts with charge-offs and accounts without. According to Kolk, the average balance of accounts with charge-offs is usually higher than those without.
Kolk suggests calculating a dollar-loss rate, essentially a charge-off rate in dollars, that allows the institution to simply calculate the expected dollar loss among each specific risk tier.
To find this, take the ratio of average charge-off account balances to average non-charge-off account balances and multiply that by the charge-off rater per account. The dollar-loss rate is what the credit union can reasonably expect to charge-off out of every $100 loaned.