By Steve Wofford
Loan pricing becomes considerably more difficult when interest rates are moving quickly. Funding costs change, competitors reposition, borrower demand responds, and yesterday’s attractive rate can become economically unsustainable surprisingly quickly. The natural reaction is to watch competitors and adjust rates accordingly.
There is nothing inherently wrong with that approach. Financial institutions operate in competitive markets, and sometimes the appropriate strategic decision is to price a loan below its fully costed economic rate. The problem is not pricing below that rate; the problem is doing it without knowing that you are doing it—or without knowing how much economic value you are giving up.
That distinction becomes particularly important in a volatile rate environment because market pricing and institutional economics can move at very different speeds.
Cost of Funds Is Not the Cost of a Loan
A surprisingly common approach to loan pricing begins with the institution’s cost of funds and adds a spread. That may provide a convenient benchmark, but it does not tell management whether the resulting loan actually produces an adequate economic return. The economics of a loan extend well beyond its funding cost.
A properly constructed pricing analysis should consider the matched funding cost through funds transfer pricing (FTP), expected credit losses, origination expenses, servicing expenses, overhead, prepayment behavior, liquidity and interest-rate risk, and the capital required to support the asset. Most importantly, those costs need to be evaluated against the institution’s required return.
For a credit union, that required return is not simply an arbitrary profitability target. Growth consumes capital. If a credit union expects to grow assets by 5% while maintaining a 10% capital ratio, it must generate sufficient earnings to support approximately a 0.50% return on assets, assuming no other additions to or distributions from capital.
Loan pricing therefore connects directly to the institution’s strategic growth and capital objectives. This is where pricing moves from a product-management exercise to a strategic financial decision.
Consider a $25,000 Auto Loan
Consider a relatively ordinary example: a $25,000 direct used-vehicle loan with a 72-month contractual term. Assume the credit union is considering a 6.00% rate, expects an 8% annual prepayment rate and carries a 0.50% annual loan-loss provision. In our example, the institution has a 10% capital ratio and anticipates 5% annual growth, producing a 0.50% target RAROA.
Six percent might look perfectly reasonable when viewed against competitors, and it might even be necessary to generate the desired volume. But market competitiveness and economic profitability are two different questions.
When the loan is evaluated using a fully costed RAROA methodology, the picture changes substantially. The example generates $1,582 of annual revenue against $2,150 of expenses, including a 5.12% marginal FTP cost, origination expense, servicing costs, expected loan losses and overhead. Before adjusting the rate to meet the institution’s return requirement, the resulting ROA is negative 2.27%.
The model calculates a 2.77 percentage-point rate adjustment, producing a minimum RAROA loan rate of 8.77%. At the proposed 6.00% rate, the loan is therefore being priced 277 basis points below the institution’s fully costed target rate, with an estimated negative $1,612 marginal economic contribution.
Does that mean the credit union should charge 8.77%? Not necessarily, and that is the important point.
Sometimes 6.00% May Be the Right Price
A fully costed pricing model should inform management decisions, not replace them. A credit union might intentionally offer the loan at 6.00% because it is pursuing market share, has excess capacity, sees value in the broader member relationship, wants to enter a strategically important market or needs to respond to a temporary competitive condition.
There may also be mission-related reasons for accepting a lower financial return. Credit unions are not required to maximize the profitability of every individual transaction, and strategic objectives can justify accepting less than the institution’s required economic return.
There is, however, a substantial difference between saying, “The market is at 6.00%, so we need to be at 6.00%,” and saying, “Our fully costed target is 8.77%, but we have deliberately decided to price 277 basis points below it for this specific strategic reason.”
The first is following the market. The second is managing the economics.
Volatility Makes FTP More Important, Not Less
This distinction becomes even more important when market rates are changing rapidly because the institution’s funding economics can change faster than many traditional pricing processes recognize. Using an average cost of deposits or a historical cost-of-funds measure can create a dangerous lag.
Existing deposits may still carry relatively low rates even though the marginal cost of replacing or raising funding has increased considerably. Pricing a new five- or six-year asset using yesterday’s average funding cost can consequently make the loan appear more profitable than it really is.
A properly constructed FTP methodology asks a different question: What is the economic funding cost associated with this particular asset today? That creates a consistent economic benchmark even as market rates move.
When rates rise, the benchmark changes. When rates fall, it changes again. Management can then decide whether market pricing justifies accepting more or less than the institution’s target return. The decision remains strategic, while the measurement remains disciplined.
Stop Asking Only, “What Is the Market Rate?”
Market rates matter enormously, but they answer only one side of the pricing equation. Management should know both what the market will pay and what the institution needs to earn.
Those two numbers will rarely be identical. The difference between them is valuable management information because it tells executives what the institution is gaining or sacrificing when it responds to competitive conditions.
Once that difference is quantified, management can ask much better questions. Is the additional volume worth the lower return? Are we intentionally buying market share? Does the broader relationship compensate for the concession? Is this product strategically important enough to justify the subsidy? Do we have sufficient capital and operational capacity to support the additional growth? Could those resources produce a better return elsewhere?
Those are strategic questions, and a pricing model cannot answer them for management, nor should it. What the model can do is make the economics visible so management can make those decisions with considerably better information.
Pricing Discipline Does Not Mean Pricing Rigidity
One misconception about sophisticated loan pricing is that the model dictates the rate. If the model calculates 8.77%, management must charge 8.77%. That misses the purpose of the analysis.
Pricing discipline does not mean blindly accepting a calculated rate. It means establishing an economically defensible benchmark before making a strategic departure from it. That becomes especially valuable during volatile periods because competitive pricing can change quickly, but an institution should not have to guess at the economic consequences every time it responds.
Know the fully costed rate. Know the market rate. Know the difference between them, and then decide whether that difference is worth paying.
Sometimes pricing below the fully costed rate will be exactly the right decision. Just know why—and by how much.
Steve Wofford is CEO of Kohl Analytics Group helps banks and credit unions understand profitability at a deeper level by identifying the economic contribution of products, members, customers, branches, officers, channels, and relationships. Unlike traditional approaches that rely primarily on broad cost allocations or market-based pricing assumptions, Kohl focuses on the actual costs, risks, funding requirements, capital usage, and operational activities that drive financial performance.
For more information, visit kohlag.com.
Kohl Analytics Group has made its RAROA Loan Pricing Calculator available online at no cost. The calculator uses industry-average cost assumptions unless institution-specific data are provided, so results should be treated as illustrative rather than institution-specific pricing recommendations. Try it FREE at this link. https://www.kohlag.com/loan-pricing-calculator?hs_preview=ohdCiJbf-146599500431
