Loan-Pricing Models: What to Consider for Loan Origination
Financial institutions that structure and optimize pricing for loans are able to make sure they are adequately compensated for the risk they are taking. Instead of pricing loans based on a “gut feel” or a request to match or beat competitors’ rates, institutions that utilize loan-pricing models for origination incorporate a more methodical approach.
Benefits of loan pricing
This methodical approach can help ensure the best loan and terms are matched to the borrower so that the financial institution makes the sale and keeps the customer. Loan pricing models can allow banks or credit unions to set prices based on other institution goals, too, including goals related to profitability targets or loan portfolio composition. In talking with banks, Abrigo has learned these institutions thought a conservative estimate was that they could pick up an additional 5 to 10 basis points in interest if they had more structured pricing methodologies in place.
One overall benefit of effective loan pricing is that it is one of the many ways a financial institution can optimize capital. Optimizing capital is important because it provides institutions with the ability and freedom to deploy capital for developing new products and new markets, addressing regulatory issues or navigating shifts in the macroeconomic environment. “Institutions that optimize capital can be more flexible and agile,” said Rob Ashbaugh, Senior Risk Management Consultant at Abrigo. “They can be more competitive and better prepared for changes on the horizon.”
Another benefit of having a loan-pricing policy or model is that it provides the institution with defensible measures for justifying pricing changes and for avoiding charges of discriminatory pricing, which some lenders have faced in recent years. Officials with the banking regulatory agencies recently outlined best practices they encourage as they relate to evaluating an institution’s fair lending risk, and one of those best practices was to document pricing and other underwriting criteria, including exceptions.
Considerations of loan-pricing models
What are some considerations related to loan-pricing models? According to James L. Adams, supervising examiner at the Federal Reserve Bank of Philadelphia, pricing is a key underwriting factor that should be addressed as part of a sound loan policy. A simple cost-plus loan pricing model is one method of pricing loans, he wrote in a newsletter for community banks that cites the Fed’s Commercial Bank Examination Manual (CBEM). A cost-plus pricing model requires that all related costs associated with extending the credit be known before setting the interest rate and fees, and it typically considers the following:
- Cost of funds
- Operating costs associated with servicing the loan or loans
- Risk premium for default risk and
- A reasonable profit margin on capital.
The risk premium for default risk takes into account the borrower’s risk rating as well as the risk rating of the credit facility, according to Adams.
Make more informed loan pricing decisions.
Reviewing and adjusting models
A pricing model can help an institution establish a pricing baseline, but appropriate adjustments should be made to be competitive and receive an appropriate return. Other variables that can affect pricing decisions at origination include payment structure, loan type and institutional relationships, such as those tied to the customer’s borrowing and deposits.
“Management must ensure that an appropriate pricing structure is established and implemented for each type of loan product offered,” Adams wrote. “Management should continuously evaluate and adjust rates in response to changes in costs, competitive factors, or risks of a particular product type.”
The CBEM also makes that point: “Periodic review allows rates to be adjusted in response to changes in costs, competitive factors, or risks of a particular type of extension of credit.” (See the PDF: Section 2040, page 265.)
Of course, because risks can vary so much across borrowers and loan types, setting the loan’s risk premium for default can be one of the most difficult aspects of loan pricing. “That risk premium is all about strategy,” Ashbaugh said. “It might take into account where the bank thinks interest rates are going to be, what its appetite for risk is, as well as other factors.
Some loan-pricing models assign a predetermined premium based on the risk rating of the borrower, while others can be more complex, Ashbaugh said. “It’s almost like making sausage,” he said. “Each bank has its own strategy and processes – its own ingredients for the sausage, so to speak – so the loan-pricing model will be a little different at each institution.”
If an institution is interested in systemizing the loan-pricing process for new-loan origination as well as annual reviews, Sageworks Loan Pricing powered by Abrigo integrates with other Abrigo origination and portfolio administration solutions to calculate a defensible and consistent price. In addition, Abrigo offers a webinar on loan-pricing factors to consider and how to handle the loan pricing formula in a changing rate environment. Register for the webinar here.