In a previous article, we discussed the fair lending benefits of having a profitable and risk-based loan pricing strategy. In this post, we dissect the specific components that comprise an effective approach.
In terms of fair lending compliance, loan pricing should be one of the easiest aspects to manage. Underwriting can be fairly complex with a degree of subjectivity due to the need to qualify certain characteristics of a credit profile. Loan pricing, on the other hand, should be very straightforward. While underwriting can involve a wide range of circumstances that differ for individual loans, pricing considerations are finite.
There are (3) broad considerations in formulating an appropriate loan pricing strategy. These are costs, risk, and profit.
All of these can be measured and incorporated into this structure. The degree of precision by which they can be quantified will determine the level of efficiency and profitability of an institution’s loan pricing once integrated into the pricing structure. Let’s examine each of these individually.
Cost of Funds – As with each attribute, there are different ways this can be measured. The simplest is to consider the institution’s interest expense.
Capital Costs – To the extent a loan may impair capital, and this should be a consideration.
Overhead – Overhead is the institution’s cost to operate. Again, with all of the elements, this can be measured in different ways and can vary over time.
Fixed Costs – Fixed costs are the fixed portion of the expense of origination, processing, and servicing an additional loan.
Variable Costs – Variable costs are the variable portion of the expense of origination, processing, and servicing an additional loan.
Loan products carry varying degrees of risk, as do the credit characteristics to which they are underwritten. Higher risk loans are more costly because of the higher probability of default but they also have more carrying costs due to servicing. Loans should have a risk premium assigned as part of the pricing structure.
Finally, loans should have a margin above the aforementioned factors. This represents the actual profit to the institution above its cost and taking into account risk.
As we have stressed throughout this post, there are varying ways to apply the above measures. Institutions may also differ in terms of their loan product concentrations as well as desired profitability and risk tolerance. Regardless of how they are measured and applied, a well formulated pricing policy should include all of these. Additionally, with the exception of competition, pricing practices that do not affect one of these – cost, risk, or profit – should most likely be avoided from a fair lending standpoint.