Best Practices for Loan Pricing & Structures

Being able to price and structure commercial loans accurately is absolutely critical to a financial institution’s profitability and success, especially when there’s uncertainty around interest rates and overall economic performance as we progress into 2024.

A strong credit analyst plays an essential role by ensuring loan structures and pricing align with both the bank’s risk tolerance and return on equity targets. This goes for new deals, as well as existing credits. The good news is that technology can equip credit analysts with the information needed to sort through the many the factors that go into pricing and structuring a loan – from cost of funds, risk premiums, and other overhead costs and much more.

This analysis is more important than ever as interest rates may change later in the year and competition for low-cost deposits remains fierce. This blog examines some of the various pricing strategies banks can employ to ensure borrowers’ needs are met while optimizing their net interest margin.

Loan Pricing Strategies

There are various loan pricing strategies that banks can use to optimize margins, including risk-based pricing and relationship-based pricing. While the profitability of the loan should influence pricing, it shouldn’t be the only factor. Community financial institutions should instead zoom out and look at the entire relationship with the customer or borrower, as well as their institution’s overall risk tolerance, to determine pricing for different loan types. 

Let’s first examine the different types of loan-pricing models and scenarios in which they may be most applicable.

Tiered pricing

Tierd pricing involves assigning different interest rates to different loan amounts. Banks can use this strategy to incentivize their more valuable customers to take larger loans, leading to higher interest income for the bank and a deeper relationship with the customer. For instance, a bank could offer a lower interest rate on loans above a certain threshold (i.e.,$100,000), to encourage customers to borrow more.

Risk-based pricing

Risk-based pricing involves adjusting the interest rate based on the risk profile of the borrower. Banks can use this strategy to compensate for the higher risk of default associated with certain borrowers. For instance, a borrower with a high credit score and a low debt-to-income ratio could be offered a lower interest rate than a borrower with a low credit score and a high debt-to-income ratio.

Relationship pricing

Relationship pricing offers preferential interest rates to customers who have a long-standing relationship with the bank. Banks can use this strategy to incentivize customers to consolidate their financial relationships from other financial services with the bank. For example, a customer who has a checking account, savings account, and mortgage with the same bank could be offered a lower interest rate on a new loan. The more relationships, the less likely a customer is to leave.

Dynamic pricing

Dynamic pricing involves adjusting the interest rate based on market conditions, including supply and demand. Banks can use this strategy to stay competitive and adjust their pricing in real-time based on market trends. For example, if a bank notices that demand for a certain type of loan is increasing, it could adjust its interest rates upward to capitalize on the trend.

Banks should choose the strategy that works best for their specific needs and goals. This is where having a partner, plus the right technology can be a game-changer because it enables the bank accurately price loans based on market factors and the pricing strategy the bank wants to pursue.

Close More Deals

It’s also helpful to have the ability to run “what if” pricing scenarios. This helps the bank’s team and borrower arrive at a pricing structure that works for everyone, as the two examples below illustrate:

• If a borrower is taking out a long-term term loan, a prepayment penalty helps the bank retain some margin before a borrower attempts to refinance with you or with someone else. Refinancing higher-rate debt is commonplace when interest rates fall, as they are expected to later this year.
• Or, a commercial borrower may agree to bring a large level of deposits to the bank in exchange for preferential pricing on credit. Other business, such as payroll or treasury business could also result in more preferential credit pricing for the customer and more total business from the customer for the financial institution.

Financial institutions can pursue several different pricing strategies when lending to commercial customers.

Whatever strategy a financial institution chooses to pursue, it’s critical to have the right technology to monitor changing macroeconomic conditions (i.e., did interest rates change?) and the financial condition of the business (i.e., did cashflow decrease or uncollectable accounts increase in the last 30 days?).

With the right tools and processes in place, a bank’s credit risk team and relationship managers can work together to present loan terms and pricing that is competitive for the customer and profitable for the financial institution.

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Podcast: Commercial Loan Pricing in Today's Rate Environment

Author Bio

Baker Hill empowers progressive financial institutions to increase revenue, reduce risk, and drive more profitable relationships.

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