How do lenders set interest rates on loans?
A discussion of the concepts lenders use to determine interest rates.
Published November 1, 2000 | November 2000 issue
For many borrowers, the factors that determine a bank's interest rate are a mystery. How does a bank decide what rate of interest to charge? Why does it charge different interest rates to different customers? And why does the bank charge higher rates for some types of loans, like credit card loans, than for car loans or home mortgage loans?
Following is a discussion of the concepts lenders use to determine interest rates. It is important to note that many banks charge fees as well as interest to raise revenue, but for the purpose of our discussion, we will focus solely on interest and assume that the principles of pricing remain the same if the bank also charges fees.
Cost-plus loan-pricing model
A very simple loan-pricing model assumes that the rate of interest charged on any loan includes four components:
- the funding cost incurred by the bank to raise funds to lend, whether such funds are obtained through customer deposits or through various money markets;
- the operating costs of servicing the loan, which include application and payment processing, and the bank's wages, salaries and occupancy expense;
- a risk premium to compensate the bank for the degree of default risk inherent in the loan request; and
- a profit margin on each loan that provides the bank with an adequate return on its capital.
Let's consider a practical example: how this loan-pricing model arrives at an interest rate on a loan request of $10,000. The bank must obtain funds to lend at a cost of 5 percent. Overhead costs for servicing the loan are estimated at 2 percent of the requested loan amount and a premium of 2 percent is added to compensate the bank for default risk, or the risk that the loan will not be paid on time or in full. The bank has determined that all loans will be assessed a 1 percent profit margin over and above the financial, operating and risk-related costs. Adding these four components, the loan request can be extended at a rate of 10 percent (10% loan interest rate = 5% cost of funds + 2% operating costs + 2% premium for default risk + bank's targeted profit margin). As long as losses do not exceed the risk premium, the bank can make more money simply by increasing the amount of loans on its books.
The problem with the simple cost-plus approach to loan pricing is that it implies a bank can price a loan with little regard to competition from other lenders. Competition affects a bank's targeted profit margin on loans. In today's environment of bank deregulation, intense competition for both loans and deposits from other financial service institutions has significantly narrowed the profit margins for all banks. This has resulted in more banks using a form of price leadership in establishing the cost of credit. A prime or base rate is established by major banks and is the rate of interest charged to a bank's most creditworthy customers on short-term working capital loans.
This "price leadership" rate is important because it establishes a benchmark for many other types of loans. To maintain an adequate business return in the price-leadership model, a banker must keep the funding and operating costs and the risk premium as competitive as possible. Banks have devised many ways to decrease funding and operating costs, and those strategies are beyond the scope of this article. But determining the risk premium, which depends on the characteristics of the individual borrower and the loan, is a different process.
Credit-scoring systems and risk-based pricing
Because a loan's risk varies according to its characteristics and its borrower, the assignment of a risk or default premium is one of the most problematic aspects of loan pricing.
A wide variety of risk-adjustment methods are currently in use. Credit-scoring systems, which were first developed more than 50 years ago, are sophisticated computer programs used to evaluate potential borrowers and to underwrite all forms of consumer credit, including credit cards, installment loans, residential mortgages, home equity loans and even small business lines of credit. These programs can be developed in-house or purchased from vendors.
Credit scoring is a useful tool in setting an appropriate default premium when determining the rate of interest charged to a potential borrower. Setting this default premium and finding optimal rates and cutoff points results in what is commonly referred to as risk-based pricing. Banks that use risk-based pricing can offer competitive prices on the best loans across all borrower groups and reject or price at a premium those loans that represent the highest risks.
So, how do credit-scoring models and risk-based pricing benefit the borrower who only wants a loan with reasonable repayment terms and an appropriate interest rate charge? Since a bank is determining a reasonable default premium based on past credit history, borrowers with good credit histories are rewarded for their responsible financial behavior. Using risk-based pricing, the borrower with better credit will get a reduced price on a loan as a reflection of the expected lower losses the bank will incur. As a result, less risky borrowers do not subsidize the cost of credit for more risky borrowers.
Other risk-based pricing factors
Two other factors also affect the risk premium charged by a bank: the collateral required and the term, or length, of the loan. Generally, when a loan is secured by collateral, the risk of default by the borrower decreases. For example, a loan secured by a car typically has a lower interest rate than an unsecured loan, such as credit card debt. Also, the more valuable the collateral, the lower the risk. So it follows that a loan secured by the borrower's home typically has a lower interest rate than a loan secured by a car.
However, there may be other factors to consider. First, the car may be easier to sell, or more liquid, making the risk of the loan lower. Second, the term, or length of a car loan is usually short—three to five years—as compared to the 15- to 30-year term of a home loan. As a general rule, the shorter the term, the lower the risk, since the ability of the borrower to repay the loan is less likely to change.
Assessing the interplay of credit score, collateral and term to determine the risk premium is one of a lender's most challenging tasks. Whether loan-pricing models are based on a simple cost-plus approach or price leadership, use credit-scoring or other risk-based factors, they are valuable tools that allow financial institutions to offer interest rates in a consistent manner. Knowledge of these models can benefit customers as well as banks. Although it cannot help customers make their payments, an awareness of loan-pricing processes can ease the uncertainty that may be involved in applying for a loan.
Matthew D. Diette is a field supervisory examiner in the Community and Regional Banking section of the Banking Supervision Department, Federal Reserve Bank of Minneapolis.
How does credit scoring work?
To determine a credit score, lenders use credit-scoring software, which analyzes data from a large pool of borrowers. Most lenders rely on the credit-scoring software developed by Fair, Isaac and Company, with data gathered by the three major credit reporting agencies: Experian; Equifax, Inc.; and Trans Union Corporation.
When a customer's name and address are entered into a credit-scoring program, a complete credit history is obtained from one of the three credit-reporting agencies. Through a series of calculations, the history is analyzed and compared to the histories of other borrowers. The customer is then assigned a credit score, which is usually between 400 and 825.
A score above 710 is normally considered a good credit risk, while a score under 620 is considered a very high risk. Customers in the latter category have blemishes or irregularities in their credit histories and are often referred to as "subprime" borrowers. So what is the benefit of knowing a credit score? The information is vital for lenders, because a customer with a score of 710 has a statistically determined default rate of only 1 in 21, while a customer with a score of 680 has a default rate of 1 in eleven.
Although the calculations that determine credit scores are complex, obtaining your credit history is fairly simple. You have the legal right to see your credit report and can request it from any of the three major credit reporting agencies.
Lenders are not obligated to share your credit score with you when you apply for a loan, but there are signs that this may be changing. According to the November 13, 2000, issue of Newsweek, Fair, Isaac and Company recently took steps to better explain credit scores to lenders, so they can convey the information to customers. And, according to the article, Fair, Isaac plans to make credit scores available to customers soon through Experian and Equifax, while Trans Union plans to release scores on its own.