Loan Pricing: Components, Formula, Methods [Followed by Commercial Banks]

Methods of Loan Pricing followed by Commercial Banks

Banks are the major financial institutions that intermediate between lenders and actual borrowers.

For the inter-mediation, banks are to pay the fund providers as ultimate lenders and charge actual borrowers. A bank acquires funds through deposits, borrowings, and antiquity, recognizing each source’s costs and the resulting average cost of funds to the bank.

The funds are allocated to assets, creating an asset mix of earning assets, such as loans, and non-earning assets, such as banks’ premises.

What is Loan Pricing?

The price that customers are charged for using an earning asset represents the sum of the costs of the banks’ funds, the administrative costs, e.g., salaries, compensation for non-earning assets, and other costs.

If pricing adequately compensates for these costs and the customer is fairly .based on the funds and service received. The loan price is the interest rate the borrowers must pay to the bank and the amount borrowed(principal).

The price/interest rate is determined by the true cost of the loan to the bank(base rate)plus the profit/risk premium for the bank’s services and acceptance of risk.

Components of True Cost of a Loan

The components of the true cost of a loan are:

  1. Interest expense,
  2. Administrative cost, and
  3. Cost of capital

These three components add up to the bank’s base rate. The risk is the measurable possibility of losing or not gaining the value. The primary risk of making a loan is repayment risk, which is the measurable possibility that a borrower will not repay the obligation as agreed.

A good lending decision minimizes repayment risk. The risk premium is the price a borrower must pay to the bank for assessing and accepting this risk.

Since the past performance of a sector, industry, or company is a strong indicator of future performance, risk premiums are generally based on the quantifiable historical amount of losses in that category.

Loan Pricing Formula

Price of the loan(Interest Rate Charge) = Base Rate + Risk Premium.

Interest-Based Loans By Traditional Banks

Pricing ethodCharacteristics
Fixed-rateThe loan is written at a fixed interest rate which is negotiated at an origination. The rate remains fixed until maturity.
Variable-rateThe rate of interest changes based on the minimum rate from time to time, depending on the demand for and supply of funds.
Prime rateUsually, a relatively low rate is offered to highly honored clients for a track record.
The rate for general customerThis rate is applied to general borrowers’. This rate is usually higher than the prime rate.
Caps and FloorsFor loans extended at variable rates, limits are placed on the extent to which the rate may vary. A cap is an upper limit, and a floor is the lower limit.
Prime timesThis special rate is a number of times greater than the prime rate. If the loan’s maturity is increased or decreased, this rate will also be increased or decreased in a multiple.
Rates on another basisThe interest rate can also be determined based on the current interest rate of debt instruments or the regional index of change of interest/price.

This rate is similar to the prime rate except that the base is different. A rate can be a bit lower or higher than the prime rate. Examples include the regional index or other market interest rates, such as the CD rate.

Determining Loan Price Without Interest

Compensating balancesDeposit balances that a lender may require to be maintained throughout the period of the loan. Balances are typically required to be maintained of average rather than at a strict minimum.
Fees, charges, etc.After sanctioning credit but before disbursing the amount to the borrower, a charge is taken for this interim period.

This charge helps to prevent the loan taker from making unnecessary delays in taking the loan. Apart from special/priority cases, no interest but 3% – 5% service is charged on small loans.

17 Factors in Loan Pricing

Loan pricing is not an exact science- it gets adjusted by various qualitative and qualitative variables affecting the demand for and supply of funds. There are 17 factors needs to considered for loan pricing.

  1. Amount of loanable fund
  2. Cost of bank fund
  3. Administrative and transaction cost
  4. Overhead expenses
  5. Expenses for credit investigation and credit analysis
  6. Security maintenance of expenses
  7. Supervision and collection expenses
  8. Amount of risk of loan and cost of risk
  9. Amount of bad debt
  10. Bank customer relation
  11. Earning possibility from the alternative use of fund
  12. Shareholders expectation of dividend
  13. Guidance of the government and bank regulatory agencies
  14. Number of competitors and their capacity to control the loan market
  15. Nature of loan price by competitors
  16. Risk of increase and decrease of interest rate
  17. Possibility of raising funds through other alternatives

Internal Factors in Loan Pricing

Amount of loanable fund

Before determining the appropriate price for the loans, the bank authority must reckon the amount of available loanable funds. If banks have a larger volume of surplus funds, loans may be provided even with low-interest rates and vice versa.

Cost of bank fund

Banks have to incur different types of expenses for utilizing the funds. If the interest payable to depositors and expenses for investment are smaller than the interest, the interest rate may be lower.

Administrative and transaction cost

At the time of loan pricing, banks should consider and estimate the expenses for loan processing and other administrative expenses of loan sanctioning. The interest income from the loan should be justified by considering the administrative and transaction costs.

Overhead expenses

If the overhead expenses are larger in amount, the loan should be priced accordingly.

Expenses for credit investigation and credit analysis

To analyze the loan application, banks need to collect accurate, relevant, and complete information. This information collection is costly, no doubt.

On the other hand, banks need to establish a method of evaluation and pay expert executives to analyze the information collected. The more costly the information collection is, the higher the interest rate on loans would be logical.

Security maintenance of expenses

Banks must determine the expenses for maintaining the small and large-sized assets kept as collateral.

Banks must ponder that the expenses for the maintenance of security should be lower than the interest received on that loan. The bank should not sanction that loan if a bank finds that it will incur more expenses to maintain the assets to be held as security.

Supervision and collection expenses

When determining the interest to be charged on loan, a bank must consider the supervision and collection expenses.  If the expected interest revenue exceeds the expected supervision and collection expenses, the bank should sanction the loan and vice versa.

Amount of risk of loan and cost of risk

A bank must consider the associated risk for the loan and the expenses due to risk.

If the cost of risk to grant the loan is lower than the expected interest revenue from the loan, the loan should be granted. If the quantum & cost or risk is higher than the expected interest revenue, the loan request should be discarded.

Amount of bad debt

Before sanctioning a loan, a commercial bank must estimate the probable uncollectible portion of the expected portion of bad debt in the total loan amount. If it is higher, the interest rate should be higher and vice versa.

Bank customer relation

If there is a good term between the bank and the customer, the extent and demand for loans will increase.

As a result, loan collection will be easier, and the relatively lower interest rate will suffice. On the other hand, if a bad relationship exists between these two parties, the amount of bad debt will Tile up, which will increase the loan expenses abnormally, and a higher rate of interest needs to be charged.

Earning possibility from the alternative use of fund

Banks must determine the opportunity cost of using the fund elsewhere. Banks must compare the amount of return from any other alternative investment with the return from the loan amount. After considering this, banks should fix the price of the loan.

Shareholders expectation of dividend

After considering the expected dividend rate or bonus to be offered to shareholders, a bank should determine the price of the loan.

External Factors in Loan Pricing

Guidance of the government and bank regulatory agencies

If there is no intervention of government or bank regulatory authorities, the market price for loans is determined by the interaction of the supply of loanable funds and the demand for loans.

The government or bank regulatory authority can increase or decrease the limit of the market rate of loans to materialize the planned economic development and to increase or decrease the money supply. So, banks must consider the direction of government and bank regulatory authorities at the time of loan pricing.

Number of competitors and their capacity to control the loan market

A commercial bank should price its loan after considering its (the bank’s) importance in the loan market, the extent of loanable funds of the competitor banks, and the competitor’s ability to control the market. It should be remembered that the more the market share of a bank is, the more controlling power over the market it has- higher may be the rate of interest.

Nature of loan price by competitors

If a bank sanctions Ioan at a higher rate and the adjacent competitor banks start to provide loans at a lower rate, loan clients may go to the competitor banks for the loan. So. a bank should determine the price of loans after considering the price offered by the competitors.

Risk of increase and decrease of interest rate

The bank should analyze the trends of a few previous years’ behaviors of interest rates changes. The bank should also try to predict the extent of increase or decrease in the given period. Otherwise, the bank may face difficulties in achieving its established loan targets.

Possibility of raising funds through other alternatives

If the borrowers can manage funds from the money market at a relatively lower cost, they will not go for the expensive option, i.e., taking loans from the bank. So, a commercial bank must consider the interest rate on alternative money market securities at the time of loan pricing.

Subscribe To Our NewsLetter ⁄
Read Related Posts /

Leave a Comment