What Is A Loan Pricing Program?

Loan pricing plays a vital role in the lender's asset/liability management program with these decisions having a direct effect on credit risk and earnings. Lenders must price their loans appropriately, ensuring that all costs are covered, risk is accounted for and managed, and sufficient capitalization is available for the lender's long-term viability. In addition, the pricing must also consider competitor rates as well as meet the borrower's needs. Like other competitive products, pricing requires a delicate balance between meeting organizational and borrower needs.

Not only is loan pricing crucial to the financial institution's success, FCA regulations require lenders to have formal policies in place that cover everything from various types offered, factors involved in computing or adjusting interest rates, and compliance policies to methodologies for monitoring pricing and their policy compliance.

Lenders create internal programs to ensure regulatory compliance as well as help loan officers make the best pricing decisions possible. While each institution can adopt their own methodologies, most programs address the following factors:

• Cost of funds – These costs are usually identified and determined by the bank's treasury department.
• Cost of operations – These costs are the institution's operating costs such as rent, salaries, insurance, training, IT infrastructure, and so on.
• Credit risk requirements – All loans are inherently risky, with some being riskier than others based on the borrower's credit history and other factors. Credit risk requirements are used to ensure that interest rate charged reflects the level of risk assumed (i.e., riskier loans have higher interest rates).
• Customer options – programs often allow for customer options such as caps on interest rates or prepayment rights. These options add risk which should be priced into the loan product.
• Interest payments / amortization – How interest is applied to a loan and how the loan amortizes can affect earnings and profitability.
• Capital investments or "loanable funds" – This refers to how much the lender has invested and thus, the amount it must borrow to fund operations along with its loan portfolio.
• Capital and earnings requirements – Lenders must understand their capital and earnings requirements in order to establish an effective earnings strategy, which plays an important role in pricing loans.

Each lender has its own program based on its unique needs and strategies. Some use simple methodologies (such as matching the competition) while others use more complex models. Models can assist lenders in establishing prices, often taking the form of a spreadsheet or calculator program. The officer simply inputs information and the program calculates the appropriate rate based on the information contained in the pricing model such as interest rate, fees, projected volume, terms, cost of funds, operating expenses, and so on.

Specialized pricing software that goes much deeper than a simple spreadsheet or calculator is also available. Software can ensure that the requirements established in the formal policy are consistently followed. With such as system in place, officers can quickly price loans that comply with the institution's formal policy.