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A Method for Accounting for Risk in Lending.
GEORGIA INST OF TECH ATLANTA
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Credit managers face the difficult task of determining the expected profit from consumer loans. This is particularly formidable because there is not as much information available about loan applicants as there is about other investment decisions such as bonds or the stock market Chmura 95. How then is a credit manager to determine if a loan at a specified interest rate is profitable or whether the interest rate should be raised to increase profitability and compensate for risk, or decreased to increase competitiveness Many lending institutions, specifically furniture retailers, do not use scientific methods for determining their risk of payment defaults on loans to customers. Techniques that exist for accounting for or compensating for risk vary in their scope from subjective increases in the lending rate to formulas involving various compensating factors which tell the lender the interest rate to charge. Many of these techniques will be cited in chapter II. None, however, seem to involve calculating a rate based directly on the risk of default. The nonscientific methods used by lenders to account for risk can result in two problematic situations lenders may not charge a high enough rate on a risky loan which results in unexpected losses and lenders may charge too high a rate and lose business because of competition with lower rates.
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