Personal loan interest rates are important to determine by the borrower. However, for many borrowers, the factors that determine a bank’s interest rate are a mystery.

All of us must know the answers to a few questions like:

  1. How does a bank decide what should be the rate of interest?
  2. Why does the bank charge different interest rates to different customers?
  3. Why there is a higher rate of interest for some types of loans, like credit card loans than for car loans or home loansetc.

How to determine personal loan interest rates?

Following is a discussion of the concepts lenders use to determine personal loan interest rates.

Cost and loan-pricing model

  1. The funding cost is incurred by the bank to raise funds to lend, whether such funds are obtained through customer deposits or various money markets.
  2. The operating costs of servicing the loan, which includes application and payment processing, and the bank’s wages, salaries, and occupancy expense.
  3. The risk premium to compensate the bank for the degree of default risk inherent in the loan request.
  4. The profit margin on each loan that provides the bank with an adequate return on its capital.

For Example

The 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%. Overhead costs for servicing the loan are estimated at 2% of the requested loan amount and a premium of 2% will be 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% 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% (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 number of loans on its books.

Price-leadership model

  • 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 it is the rate of interest charged to a bank’s most creditworthy customers on short-term working capital loans.
  • 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.
  • The 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. Determine 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

  • The 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 is currently in use.
  • Credit-scoring systems, which were first developed more than 50 years ago,  sophisticated computer programs used to evaluate potential borrowers and to underwrite all forms of consumer credit, including credit cards, installment loans, residential mortgages as well as home equity loans and even small business lines of credit.
  • Credit scoring is a useful tool with an appropriate default premium. It helps in determining the rate of interest charged to a potential borrower.
  • Banks that use risk-based pricing can offer competitive prices on the best loans across all borrower groups. Reject or price at a premium those loans that represent the highest risks.
  • Credit score and risk-based pricing can make the borrower take a loan with reasonable personal loan interest rates.
  • The bank determines a reasonable default premium based on the past credit history of borrowers. Bank also rewards the borrowers for their responsible behavior.
  • Risk-based pricing helps the borrower with better credit. It reduced the price on a loan as a reflection of the expected lower losses.
  • 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
    • Length of the loan.
  • However, with the secured loan 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. 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.
    • The car may be easier to sell, or more liquid, making the risk of the loan lower.
    • The time period of a personal loan is usually short as compared to a long-term home loan.
    • As a general rule, the shorter the term it is the lower the risk it will be. Since the ability of the borrower to repay the loan is less likely to change.

Simple cost

  • Assessing the interplay of personal loan credit score and term to determine the risk premium is the lender’s most challenging tasks.
  • Loan pricing models are based on simple cost and approach of price leadership. Use credit scoring or other risk-based factors. They are valuable tools that allow financial institutions to offer interest rates consistently.
  • Knowledge of these models can benefit customers, as well as banks, and awareness of loan pricing processes can ease the uncertainty that may be involved in applying for a loan.