The Pricing Challenge

A common question that you hear revolves around how to price a loan.  Now some loans do have limitations placed on their pricing if they are tied to some government program such as SBA.  But the general attitude in far too many cases when the lender has the ability to set a rate is to see what the competition is doing and then either match or slightly beat that rate. 

It is a dangerous thing to run your institution by sticking your head out the door and looking at your neighbor.  His shop is different from yours and what works for him may not work for you.  Besides, if he is the stupid one, why do you want to follow? 

Now I will concede that there are clients who are bringing you a substantial amount of business which you are forced to concede on the price.  I am not suggesting that the lender abandon this practice altogether; I am suggesting that you keep your eyes wide open when pricing.

An institution should consider a minimum threshold when considering pricing.  The threshold should account for the amounts needed to cover operational costs of the CU plus a targeted profit margin and reserve increase.  Non-interest income is then deducted from those costs.  The remainder is what needs to be earned by the net interest margin between the costs of deposits and borrowings and the earnings on loans and investments. 

This may lead the institution to attempt to move as much funds from investments to loans since the average yield on loans is higher.  That is true, but the average yield assumption fails to consider a few items.  First, typically the cost to service a loan is usually higher than the cost to service an investment.  Second, the risk in servicing loans is usually higher than investments.  We call this the risk of default or charge off.  Third, the cost of dropping rates on existing loans to attract new loans will lower your marginal yield. 

To make an apples to apples comparison between investments and loans, the costs of servicing and default need to be added to the yield on the investment.  This will give an adjusted yield that will compare to the loan rate. Servicing costs can be figured in your shop with the incremental cost of support staff, computer systems, and other items that will be used to service the new loan.  Credit risk can be calculated by looking at a stratification of the evidences of default and delinquency among various risk rates of loans in the portfolio.  Those figures, along with an analysis of the adequacy or lack thereof in your allowance accounts, will help determine the premium factor that the new loan would cost compared to the investment. 

To make the comparison the same, similar maturities or repricing periods should be considered for both. It does not make sense to compare a 2 year Treasury to a 5 year fixed loan rate or a Prime tied loan to a 5 year US Government agency.  In the same way, how a loan adjusts should be tied to a similar term index whenever possible.  So this would tie an adjustable rate for 5 years to a 5 year index, which could be a US Treasury, LIBOR or FHLB.  Matching this term will help determine the spread compared to the alternative investment or may help you more fully identify your cost of funds for that loan.  In the end, even after these adjustments, many will find the loan offers a better net yield, even after consideration of the alternative investment’s adjusted rate.  But a strategy of pricing should consider these costs.