Loan pricing is a critically important function in a financial institution's operations. Loan-pricing decisions directly affect the safety and soundness of financial institutions through their impact on earnings, credit risk, and, ultimately, capital adequacy. As such, institutions must price loans in a manner sufficient to cover costs, provide the capitalization needed to ensure the institution's financial viability, protect the institution against losses, provide for borrower needs, and allow for growth. Determining the effectiveness of loan pricing is a critical element in assessing and rating an institution's capital, asset quality, management, earnings, liquidity, and sensitivity to market risks.
The following is a list of factors that institutions should consider in loan pricing.
1. Cost of funds: The cost of funds is applicable for each loan product prior to
its effective date, allowing sufficient time for
loan-pricing decisions and
appropriate notification of borrowers.
2. Cost of operations: The salaries
& benefits, training, travel, and all other
operating expenses. In addition, insurance expense, financial assistance expenses are imposed to loan pricing.
3. Credit risk requirements: The provisions for
loan losses can have a material impact on loan pricing, particularly in times
of loan growth or
an
increasing credit risk environment.
4. Customer options and other IRR: The customer
options like right to prepay the loan, interest rate caps, which may expose institutions to IRR. These risks must be priced into loans.
5. Interest payment and amortization methodology: How interest is credited
to
a given loan (interest first or
principal first) and amortization considerations
can have a impact on profitability.
6. Loanable funds: It is the amount of
capital an institution has invested in
loans, which determines the amount an institution must borrow to fund the loan portfolio and operations.
7. Patronage Refunds & Dividends: Some banks pay it to their
borrowers/shareholders
in lieu of lower interest rates. This approach is preferable
to
lowering interest rates.
8. Capital and Earnings Requirements/Goals: Banks must first determine its capital requirements and goals in order to determine its earnings needs.
9. expense of credit investigation and analysis
10. probability of alternative profit.
11. bank customer relationship.
12.security maintenance expense.
13. risk of fluctuation of
interest rate.