Many borrowers feel the elements deciding a bank’s interest rate must be clarified. What makes a bank determine what interest rate to offer? Why do they charge different rates of interest for different customers? Why do they offer higher rates on certain types of loans, for example, those with credit cards, compared to mortgage loans for homeowners?
The following article will discuss the methods lenders employ to calculate interest rates. The key is to remember that many banks have fees in addition to interest to generate revenues; however, to focus this discussion, we will concentrate on interest only and assume the fundamentals of pricing will remain identical if a bank also has fees.
Cost-plus model for loan pricing
A simple model for loan pricing supposes that the amount of interest on a loan has four elements:
- the cost of funding the bank has to obtain funds to lend the funds, regardless of whether they come from customer deposits or other money markets;
- the operational costs associated with financing the loan. These include processing the application and payment as well as the bank’s salaries as well as occupancy and salaries;
- an amount of risk to cover the risk of default that is inherent to the request for loan and
- A profit margin on every loan gives the bank an adequate return on capital.
Let us look at a concrete illustration of the method by which this loan-pricing model comes with an interest rate for an application for a loan of $10,000. The bank has to obtain the funds needed to lend at five percent. The overhead expenses for servicing the loan are estimated to be two percent of the loan amount. Additionally, a fee of 2 percent is imposed to cover the bank’s risk of default or the possibility that the loan may not be paid in due time or entirely. The bank has decided that each loan will be assessed as having a profit margin of one percent in addition to the operating, financial, and risk-related expenses. By combining these four elements to the loan request, it can be extended at the rate of 10 percent (10 percent loan interest rate = 5% of the cost of funds minus 2 percent operating expenses + the 2% cost for risk of default + the bank’s profit margin target). If losses do not exceed risk cost, the bank can make more money by expanding the loans it has on its books.
Model of Price-Leading
The issue with the basic cost-plus model of loan pricing is that it suggests a bank can charge the loan without regard to competitors against other loan providers. The competition affects the bank’s profit margin for loans. In the present environment of banking regulation, the intense competition for loans and deposits of other services institutions, has drastically reduced the profit margins of all banks. This has led to a rise in banks taking advantage of a price-driven pricing method to determine credit rates. A prime rate, also known as a base rate, is set by the central banks and is the interest rate paid to the bank’s highest trustworthy customers on short-term capital loans.
It is important to note that this “price leadership” rate is vital because it is an ideal benchmark for other kinds of loans. To ensure a sufficient business return under the price leadership model, the banker should keep the operational and funding costs, as well as the risk cost, as competitive as possible. Banks have devised various strategies to cut down on operating and funding expenses, but those methods are outside the subject in this piece. However, determining the risk-free rate based on the particulars of the borrower and the loan is an entirely different procedure.
Risk-based pricing and credit-scoring systems
The risk associated with a loan differs depending on its specific characteristics, and the borrower assigning a default risk or default cost is among the most challenging aspects of pricing loans.
A variety of risk-adjustment strategies are employed. Credit-scoring methods, which were initially developed over half a century ago, have advanced computer programs that are used to assess the potential of borrowers and to guarantee every type of consumer credit, such as installment loans, credit cards and residential mortgages as well as home equity loans, and even small-business credit lines. The programs can be created at home or purchased from vendors.
Credit scoring can be a helpful instrument to determine the appropriate default rate in determining the amount of interest to be charged to potential lenders. The process of setting this default rate, as well as determining the most optimal rates and cutoffs, results in what is known as “risk-based” pricing. Banks using risk-based pricing can provide affordable rates on the most profitable loans for all types of borrowers and reject or set at the highest cost for loans that carry the most significant risk.
How do credit-scoring models and pricing based on risk favor the borrower who seeks a loan with acceptable repayment terms and a reasonable interest rate? Because banks determine the appropriate default rate in light of previous credit history, those with good credit histories are rewarded for their fiscal responsibility. By using risk-based pricing, the one with the best credit rating will pay a lower price on a loan because it is an indication of the lower losses the bank is likely to be able to incur. In the end, the less risky borrowers do not support the cost of credit to the riskier borrowers.
Other risk-based pricing elements
Two other aspects also impact the risk cost paid by banks, the collateral needed, and the term or length that the borrower can repay. Generally, when the loan is secured with collateral, the borrower’s default likelihood reduces. For instance, a loan secured by cars typically comes with an interest rate lower than a loan that is not secured, like a credit card. Furthermore, the more valuable collateral, the less risk. This means that loans secured by the borrower’s property typically have a lower interest rate than loans secured by a vehicle.
However, there are other aspects to take into consideration. The first is that the vehicle may be more affordable to sell or be more liquid, which makes the chance of a loan less. Additionally, the term or duration of the car loan is typically shorter–between three and five years–compared to the 15-to-30-year term of the home loan. In general, the shorter the duration, the more risk-free as the holder’s capacity to repay the loan is more likely to remain the same.
One of the lenders ‘ most demanding tasks is assessing the interplay between the credit score and collateral terms to calculate the risk-free rate. The loan-pricing models, whether founded on a simple cost-plus model or a price-leadership or employ credit-scoring, as well as other risk-based elements are valuable instruments that permit financial institutions to provide rates of interest uniformly. Knowing these models can help customers and banks. While it cannot help consumers pay for their loans, knowledge of loan pricing processes can help ease the anxiety associated with making a loan application.
