Methods of Loan Pricing followed by Commercial Banks

Banks are the major financial institutions, which inter mediate between actual lenders and actual borrowers.

For the inter-mediation, banks are to pay to the fund providers as ultimate lenders and charge actual borrowers.

A bank acquires funds through deposits, borrowings ,antiquity recognizing the costs of each source 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.

The price that customers are charged for the use of 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 customer to be fair .based on the funds and service received.

The price of loan is the interest rate the borrowers must pay to the bank, in addition to the amount borrowed(principal).

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

The components of true cost of a loan are:

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

These three components add-up to the banks base-rate .Risk is the measurable possibility of losing or not gaining the value.

The primary risk of making loan is repayment risk, which is the measurable possibility that a borrower will not repay the obligation as a agreed.

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

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

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

Loan pricing is not an exact science- get adjusted by various qualitative as well as qualitative variables affecting demand for and supply of funds. These are several methods of calculating loan prices.

A. Interest Based Loans by traditional banks

Pricing methodCharacteristics
Fixed rateThe loan is written at fixed interest rate which is negotiated at an origination. The rate remains fixed until maturity.
Variable rateThe rate of interest changes basing on the minimum rate from time to time depending on the demand for and supply of fund.
Prime rateUsually, relatively low rate offered to the highly honored clients for track record.
Rate for general customerThis rate is applied for 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 the upper limit and a floor is the lower limit.
Prime timesThis special rate is number of times greater than the prime rate. If the maturity of the loan is increased or decreased, this rate will also be increased or decreased in a multiple.
Rates on other basisThe interest rate can also be determined on the basis of current interest rate of debt instruments or the regional index of change of interest/price.

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

B. Determining loan price without interest

Pricing methodCharacteristics
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 delay in taking loan.

This apart, on special/priority cases, no interest but 3% – 5% service is charged on small loans.