How do banks price loans (Interest Rates)?

Banks are structured and operate differently. However, the loan Interest Rate charged by a bank is determined by two characteristics, namely bank-specific characteristics and customer-specific characteristics..


  • Bank Specific Characteristics (Cost of Funds & Margins)

    1. Banks will price loans based on their Cost of Funds. This is a cost that is influenced by both wholesale deposits and deposits from individual bank customers (also known as retail deposits).
    2. The wholesale deposit rates significantly influence the loan interest rate. For example, corporations typically require a high interest rate to be paid for the deposit they keep with a bank; the bank therefore will price most of its loans based on that wholesale deposit, plus margin to cover the bank''s operational costs, risk and return to shareholders (profit margin).
  • Customer Specific Characteristics (Risk Profile & Product Specifications)

    1. Just as banks are different, so are customers. When issuing a loan, banks will assess a customer based on that customer''s ability to repay the loan. This is called the "risk profile" of the customer. There is a price associated with the likelihood that the customer will repay the loan, or the likelihood of default.
    2. To determine the customer''s profile, a bank will use a Credit Report provided by a licenced Credit Reference Bureau. The Credit Report covers the customer''s Credit History (an account of debt obligations and repayment track record).
    3. There are also different product types. Depending on the product, there would be a cost associated with the risk the bank would take by selling the product. For example, an unsecured loan carries a higher risk than a loan secured by an asset (collateral).


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