What should you charge for a business loan? Well, that all depends, but it depends mostly on your cost of funding as well as a risk premium.

The first thing anyone should understand about pricing a loan is that a financial institution accepts deposits and loans out those funds. For the institution to pay overhead and make any profit, it must charge a higher interest rate on the loans than the interest rate it pays on deposits. Therefore, it is the interest rates you charge on deposits that will serve as the basis for pricing a loan.

Deposits are the funding source for loans, and the interest rate we pay on those deposits is the cost of those funds. There are other ways to fund loans too, such as borrowing from Fed funds, Federal Home Loan Bank (FHLB), etc. The price you have to pay for any funding source is what we consider the cost of funds.

In a perfect world, you would “match-fund” all loans, meaning 5-year deposits would be used to fund 5-year loans. No matter how you choose to fund the loans, the loan should be priced off the cost to match-fund the loan. Interest rates fixed for 5 years should use 5-year funding sources as a basis to start pricing, just like a rate fixed for 10 years should use a 10-year funding source cost basis to guide pricing.

By not match-funding a loan, you expose yourself to interest rate risk. If a 5-year loan is funded with a 10-year deposit, the institution benefits when interest rates rise but is harmed when interest rates fall. If rates fall, and loan reprices after 5 years to a lower rate, but the rate on the deposit will remained fixed!

Likewise, when a loan is not match-funded in the opposite circumstance, interest rate risk persists. If a 10-year loan is funded with a 5-year deposit, the institution will be harmed if interest rates rise and will benefit if interest rates fall. When rates rise, the institution will have to pay a higher rate on the deposit when it matures in 5 years, but the loan will not be repriced.

Now imagine an institution makes a fixed rate loan for 15 years, the NCUA maximum term. Would you be able to match fund that with a 15-year deposit? If not, you will face interest rate risk if rates rise in the next 15 years!

Match-funding is an ideal circumstance, and an institution’s balance sheet will likely be exposed to interest rate risk in some direction. When, on an aggregate basis, more assets (loans) are likely to reprice than liabilities (deposits) in a given period, we say the balance sheet is asset/rate sensitive. When more liabilities are likely to reprice than assets in a given period, we say the balance sheet is liability/rate sensitive. At any given time, the aggregate difference between the rates charged on assets and the rates charged on liabilities is known as the net interest margin.

The cost of funds is the basis to begin pricing a loan so you preserve your net interest margin, but then a risk premium needs to be added on top of that. I will address that next week in Pricing Your Loans II: The Risk Premium.