Catalyst News

The Art of Loan Pricing

by Catalyst Corporate | Nov 18, 2022

There are two kinds of art: the first is free flowing, up for interpretation and often varies in its intrinsic value. The second is a somewhat idealized form with which you can continually strive for, but never quite attain, perfection.

Loan pricing is an art of the latter kind. Truly artful loan pricing is a delicate balance between providing the best possible value to your credit union and offering a rate that members ultimately accept. For most products, however, there is no clear market indication for how to price a loan…that’s where it becomes an art. The tipping point is different for each member, loan and rate.

How to price loans

Poor loan pricing can deeply impact a credit union. Let’s look at some of the tangible and intangible results of poor loan pricing:

Tangible impacts

  • Lower earnings
  • Weaker liquidity
  • Less control of the balance sheet

Intangible impacts

  • Uncontrolled loan growth
  • Transfer of value from core members to non-core members

Financial theory suggests the existence of a “risk-free” rate. Though every loan contains some degree of risk, the U.S. Treasury rate is considered the risk-free rate in practice.

Fairly pricing a loan should build off the risk-free rate concept. Adding adjustments for borrower unique risks, such as credit, illiquidity, loan basis and cost of servicing will establish a sound loan pricing model.

Building pricing models takes time, data and patience. Testing, refining and adjusting the model to improve accuracy are vital steps before implementing any loan pricing model. What models are most useful in pricing loans? A few are listed below:

Concepts for building a loan pricing model

  • Base Rate: Using Prime or a U.S. Treasury rate for a term equaling the weighted average life (WAL) of the loan.
  • Servicing Spread: Includes the annual employee and overhead costs to process payments, make collection calls, send reminders, etc.
  • Credit Spread: Includes the average losses over time for each credit band for “like” products.
  • Liquidity Premium: Compensates for the inability to quickly turn a loan into cash without excessive loss.
  • Dealer Reserves: Accounts for the annual amortization cost of dealer reserves.
  • Earnings Spread: Compensates the credit union for deploying member funds to produce a return above the risk-free rate.

Loan stability & flexibility

Stability and flexibility are also factors to keep in mind when setting loan rates. When building a loan pricing model, using the one-week or two-week average U.S. Treasury rates can stabilize volatility in the Base Rate. It’s important to update loan pricing regularly to stay current with any market rate changes.

Consider building in a tolerance level for proposed rate changes. For example, your credit union might not want to change loan rates for a 5-basis-point change in market rates. If 25 basis points is a more realistic threshold, incorporate a tolerance level of +/- 25 basis points to create added stability. Just ensure the tolerance range does not exceed the earnings spread.

Loan pricing experience matters

Like any art, experience is one of the most important components to accurately and consistently pricing loans. Catalyst Strategic Solutions’ ALM team offers countless resources, including monthly ALM Loan Guidelines, to help credit unions make informed decisions about loan pricing and other business activities.