Method of loan Pricing:
Banks are the major financial institutions, which intermediate between actual lenders and actual borrowers. Loan Pricing is the process of determining the interest rate for granting a loan, typically as an interest spread (margin) over the base rate. For the intermediation, banks are to pay to the fund providers as ultimate lenders and charge actual borrowers. A bank acquires funds through deposits, borrowings, and equity 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 bank’s premises. The price that customers are charged for the use of an earning asset represents the sum of the costs of the bank’s 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 the 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 bank’s services and acceptance of risk. The components of the true cost of a loan are:
a) Interest expense,
b) Administrative cost,
c) Cost of capital.
These three components add up to the banks base-rate. A risk is a measurable possibility of losing or not gaining the value. The primary risk of making the loan is repayment risk, which is the measurable possibility that a borrower will not repay the obligation as an agreed. A good lending decision is one that minimizes repayment risk. The price a borrower must pay the bank for assessing and accepting this risk is called the risk premium. Since the 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 the 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.