How Do Lenders Set Interest Rate on Your Loans? | Lee Chandler

Many borrowers wonder how lenders decide on the loan interest rate. What factors do lenders
use to determine the interest rate? Why are customers charged different interest rates? The
following article will discuss an overview of how lenders determine loan interest rates.
Banks have the power to determine interest rates on deposits and the cost of loans, but they
cannot exceed limits due to competition and Fed policy. There are two models that lenders can
use: cost-plus loan-pricing model and price-leadership model.
The cost-plus loan-pricing model is a loan pricing model that includes four elements:
– Funding cost: this is the cost the bank incurs to raise loan capital, which is either through
customer deposits or various money markets;
– Operational costs: includes costs related to processing and payment of the loan, and wages
and salaries expenses;
– The risk premium to compensate the bank for the level of default risk that is inherent in the
loan request; and
– A rate of return on each loan that gives the bank an appropriate return on its capital.
One disadvantage of the cost-plus loan-pricing model is that the bank can freely price a loan
without considering the competition of its competitors. Fierce competition among lenders
directly affects the target profit, significantly reducing the profitability of the lenders. To
overcome this, many banks use price-leadership model. It is significant to set up a “price
leading" ratio which is a standard for many other types of loans. While ensuring funding,
operating costs and risk premium are at a competitive level, bank owners must maintain
business profits in many ways such as cutting funding and operating costs.
The first factor that lenders look at to determine loan interest rate is credit-scoring systems and
risk-based pricing. Credit scoring is a 50-year established and developed system which is useful
in setting premiums and determining interest rates. It is a sophisticated tool for pricing the
default premium and finding the optimal price based on the risk assessment. As the risk of a
loan varies depending on its characteristics and the borrower, banks that use risk-based pricing
may offer the best prices for loans with very low risk and rejecting or overvaluing loans with the
highest risk. Credit scoring and risk-based pricing models benefit borrowers because the bank
determines the amount of the premium that cannot be paid based on past credit history,
meaning borrowers that have good credit history will benefit from their responsible financial
behavior through receiving a discount on a loan.

Lenders also considered other risk-based pricing factors such as the collateral required and the
term of the loan. The borrower's risk of default is reduced when a loan is secured by collateral,
for example a loan secured by a car will receive a lower interest rate than an unsecured loan.
Additionally, the more valuable a collateral is, the lower the interest rate the borrower can get
due to the lower risk. In addition, there are other factors that can be considered such as the
liquidity of the loan. For example, a car is easier to sell than a house, making the risk of a loan
lower. Furthermore, a shorter loan term leads to lower risks, as borrowers' ability to repay their
debts is less likely to change.

Author: Vy Yakushenko

References:
Diette, Matthew D. (November 1, 2000). How do lenders set interest rates on loans? Retrieved
from: https://www.minneapolisfed.org/article/2000/how-do-lenders-set-interest-rates-on-

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