Pricing to Meet Your NIM Threshold

We get a lot of questions about how to determine the price on a loan.  One of the easy places to start is to price a loan to meet or exceed your Net Interest Margin of your institution.  This method is simplistic, and does not account for operational expenses or provision for loan loss reserve, but it does provide a starting point to provide some discipline to your loan pricing.

Net interest margin (NIM) is simply the average interest rate you receive on your assets less the average interest rate you pay on your liabilities.  Assets include both loans and investments for your institution.  Liabilities include deposits and any borrowings.  If your institution is heavy into investments like government securities and agencies, your income on earning assets is probably low since these items are viewed as less risky than loans.  Once you have your NIM, you know a target threshold for your institution needs to meet on a loan in order for an incremental NIM improvement to occur as a result of the new loan.

The next step is to consider the cost of funds.  You may already know this for your institution, but I would suggest that a better method is to pretend that you have to borrow the money for that loan and then are making money on the spread between what you borrow the money for and what you lend it at.  I had a boss once who said that we make money by borrowing and renting out small pieces of paper with pictures of dead presidents and founding fathers on them.  The success you will have is tied directly to the spread.

There are several different measures you can use for calculating a cost of funds.  I would suggest using an index that can correspond to your cost of funds.  Some possibilities are the US Treasury rate, Federal Home Loan Bank’s Cost of Funds or London Interbank Offered Rate (LIBOR).  Of these three indexes, it seems that US Treasuries have depressed rates in times when demand for US Debt is high.  This may artificially lower the rate and show a lower cost of funds than what you experience in your institution.  The following is a current listing of the variations in the interest rates among these three as of December 8, 2014:

Note that of the three, currently the FHLB is currently at the higher one.  I would suggest if you insist of using a US Treasury then you may want to look at a higher margin.  So select a maturity that matches the repricing term of your loan.  An example is if you have a loan that will reprice in 5 years, you will select a cost of funds rate that has the same maturity, i.e. 5 year Treasury, LIBOR or FHLB.  This becomes your cost of funds. 

If your institution has a NIM of 3% now, your 5 year loan, based upon LIBOR as cost of funds, needs to be at 4.73% or higher to create an improvement to your NIM.  So is there any reason to close a loan that has lower NIM than your current one?  In some cases yes.  Perhaps you have a borrower who keeps an average of $250K in a deposit account that pays no interest and this customer is borrowing a $1MM for 5 years.  You could think of this as having $750K at your 5 year COF base and the remaining $250K at a COF of 0%.  Using the LIBOR index, you would have a blended COF of 1.30% on the loan. You could effectively price the loan lower and still maintain profitability due to the increased business you have with the client.  Remember, your goal is relationships, not just transactions.

Again, this method is very simplistic and does not take into account many other factors.  If your NIM is adequate but you are paying another $10,000 of third party costs, your profitability will suffer.  If your NIM is slightly below the threshold but you are getting some hefty origination fees, you may have more net income.  The purpose of the NIM pricing is to instill some discipline in pricing to make your institution more successful.