Still Peeking Through the Blinds to Set Your Loan Rates?
Do you know how much it costs your credit union to book a loan and whether or not you’re making money on it? Do you use a loan pricing model to set appropriate rates, or are you letting the financial institution down the road determine your rates?
Proper loan pricing is vital to not only ensure that expenses are covered, but that you also remain competitive, manage risk and build capital.
What Really Drives Your Loan Pricing?
There are many factors that should be considered in setting loan rates, such as cost of funds, operating expenses, risk-based pricing to adequately cover collections and loan loss, the desire to help members, market conditions and regulations.
While those factors are important, in many cases, a big part of setting loan rates comes down to looking out the window to the competition across the street to see their rates. We operate in an industry with little difference between loan products, and it can be easy to fall into the trap of offering similar rates to remain competitive. After all, no one wants to lose the loan and perhaps the overall member relationship.
But before adjusting your rates to match the competition, first consider why they set the rate they did and whether it actually makes sense for your institution. It’s possible that, in an effort to remain competitive, you could lose your advantage and long-term sustainability by following a troubled institution or just by making a bad decision.
Chasing or matching low rates, or even being too slow to raise rates, could lead to several problems:
- Tighter liquidity as you drive up loan-to-share ratios
- Margin compression as interest income remains low and, perhaps, insufficient to cover the cost of funds needed to adequately support loan growth
- Reduced profitability or more reliance on fee income to cover operating expenses
- Increased credit risk by focusing more on volume rather than properly pricing for loan quality
Conversely, following the competition’s lead in raising rates may not be in your best interest either. For instance, they may have raised rates to slow loan growth due to tight liquidity, and matching that trend may inadvertently shut off your own organic growth at a time when you have plenty of room to grow.
Rethinking Your Strategy
Rather than following the rates of others, it is possible to set rates that are suitable for your own institution to cover your operational expenses and also allow you to be competitive in your market.
We recently partnered with a CUSO, TCT Risk Solutions, which has developed a loan pricing tool, that has been independently verified for accuracy, to help you set appropriate and competitive rates.
To determine those rates, TCT conducts an internal cost analysis by job function and uses your 5300 call report to break down how much it actually costs your institution to book a loan. Through this tool, you can see the cost breakdown by each loan type you offer, as well as the cost by the various terms and loan grades within each loan type.
Once the cost to book a loan is established, you can then adjust the rates to run some of the following scenarios:
- Input your institution’s current rates to see if they result in a strong or weak profit margin or are insufficient to cover costs
- Input rates across loan grades A through E for specific terms to achieve a desired weighted average spread
- Input your competitors’ current rates to see what impact matching those rates would have on your profitability
- Adjust the loan portfolio percentage by loan grade to determine if increasing your portfolio down the lending curve would make financial sense
- Input more competitive rates down the curve and see if you could better compete in your market and help more members even with a higher risk of loss
- Run a scenario for a possible loan promotion across loan grades or an individual loan to see the impact on your costs, including loss allowance, and profitability
- Create a rate sheet for your loan officers that provides acceptable rates based on a preapproved margin established by management or the board, which could help speed up the approval process
This tool can help your board and management make more informed decisions and increase your competitive advantage.
That way, you can be the leader in your market, setting rates that are not only profitable but competitive. Then, watch other institutions look out their windows to follow your lead.
Learn more about the TCT suite of services available through Vizo Financial!