The question the method answers
Large lenders answer "should this loan be written?" with a scored model and a credit team. Small independent lenders and buy-here-pay-here operators answer it at a desk, in minutes, usually on instinct. The method here is the middle path: an explicit, checkable chain from deal inputs to an economic verdict. It does not predict any individual borrower's behavior. It asks a narrower question: given typical loss behavior for this profile, does the deal's expected lifetime economics clear the lender's own hurdle?
Four lines of arithmetic
Line 1, probability of default (PD). Start with a 12-month base rate by credit-score band: roughly 1.5% at 800+, 4% at 700-749, 12% at 600-649, 20% at 550-599, 30% at 500-549, and 40% below 500. Then multiply by deal-shape adjustments: each 10 points of loan-to-value above 100 adds 25% to PD; debt-to-income above 45 adds 30-55%; each year of vehicle age past five adds 4%; and longer terms raise the per-period rate (about 0.85× at 36 months, rising ~0.12 per additional year). Finally, convert 12-month PD to lifetime PD with a term multiplier, about 1.8× at 36 months, 2.5× at 60, 2.85× at 84, capped at 85%.
Line 2, loss given default (LGD). Severity is driven by the collateral path, not the borrower. A base LGD by vehicle age (35% for near-new, 55% at four to six years, 75% past ten) is scaled by LTV at the time of default, approximated as origination LTV less about 15% of balance paydown, and bounded between 20% and 95%.
Line 3, expected loss (EL). PD × LGD × amount financed. This is the reserve-sized dollar figure the deal must earn back before it earns anything.
Line 4, lifetime ROA. Gross interest is the APR applied to the average amortizing balance (≈0.55× the amount financed) over the term. Subtract cost of funds on the same average balance, per-loan operating cost, and expected loss. Divide the remainder by the amount financed. The verdict follows mechanically: decline if lifetime PD is 50% or higher or expected ROA is negative; fund if ROA clears the lender's target; counter in between.
Two lenders, two benchmark sets
The same arithmetic prices very different books depending on the lender's own economics. Two benchmark profiles anchor the method, an independent dealer or finance company writing mid-subprime paper, and a buy-here-pay-here operator self-financing older vehicles at deeper subprime scores.
| Benchmark assumption | Independent / finco | BHPH operator |
|---|---|---|
| Cost of capital | 7.5% | 9.5% |
| Operating cost per loan | $200 | $350 |
| Target lifetime ROA | 1.5% | 3.0% |
| Typical credit score | 615 | 540 |
| Typical APR | 18% | 22% |
| Amount financed | $15,500 | $10,500 |
| Vehicle wholesale value | $14,500 | $9,000 |
| Down payment | $1,500 | $1,500 |
| Term | 60 mo | 36 mo |
| Vehicle age | 5 yr | 9 yr |
A worked deal, walked to a verdict
A synthetic deal, deliberately marginal: a 615-score borrower at 38% DTI, a five-year-old vehicle worth $13,500 wholesale, $15,500 financed at 18% APR for 60 months, against the independent-lender economics above.
| Step | Value | Read |
|---|---|---|
| LTV at funding | 114.8% | Negative equity from day one |
| Lifetime PD | 49.3% | Just under the 50% decline line |
| LGD | ~54% | Mid-age collateral, near-100 LTV at default |
| Expected loss | $4,101 | 26% of the amount financed |
| Gross lifetime interest | $7,673 | 18% on the average balance, 5 years |
| Cost of funds | −$3,197 | 7.5% on the same average balance |
| Operating cost | −$200 | Per-loan servicing assumption |
| Net profit / lifetime ROA | $175 · 1.1% | Positive, but below the 1.5% target → COUNTER |
When a counter rescues the deal, and when it can't
A counter verdict means the deal is under-priced for its risk, not unprofitable. The method searches for the single smallest change that clears the target, in order: a rate bump (half-point steps, capped at 29% APR), additional down payment ($250 steps), a shorter term (six-month steps, floor of 24), or a smaller advance. On the worked deal, the rescues are strikingly cheap. A half-point APR increase to 18.5% adds about $213 of lifetime interest on the average balance and lifts ROA from 1.1% to roughly 2.5%, clearing the target. So does $250 of additional down payment, which trims LTV, PD, and expected loss simultaneously.
The term lever, by contrast, fails on this deal at every step. Shortening from 60 to 48 or 36 months does cut lifetime PD meaningfully, but it cuts lifetime interest faster, and ROA never reaches the target. In this arithmetic, term reduction de-risks the deal and de-profits it at the same time; price and advance are the levers that actually move the verdict.
Limits
This is a decision-support heuristic, not a credit model. Its parameters are stylized calibrations to the shape of published industry default curves, not fitted coefficients, and a lender's own portfolio history should replace them wherever it exists. The score-band base rates step in cliffs, 599 versus 600 moves the base rate from 20% to 12%, where reality is smooth. The average-balance approximation (0.55×) and the fixed default-timing assumption (~15% paydown at default) are conveniences, not observations.
Finally, lifetime ROA here is net profit over the amount financed across the whole term, not an annualized figure, comparable across deals of similar term, less so across a 36-month and a 72-month note. None of this changes the core discipline the arithmetic enforces: no deal is priced until expected loss has been subtracted.