The Cost of a Loan
We hear many times throughout any given month that loan competition is really tough and that is why loan offering rates are staying low. However, many banks will bend to the competitive pressure and book a loan without realizing the potential negative impact to the bottom line.
Let’s assume that John Doe walks in looking for a $5,000,000 business loan. He tells you that the bank down the street offered him 4.125% for a 5 year balloon amortized over 10 years, and he is willing to give you the loan if you make him a 4%, 5 year balloon amortized over 10 years. Of course, he also wants this loan to be fully prepayable without any additional cost. With the 5 year Treasury currently trading near 2 percent, you decide to extend the credit and make the loan. Assuming this borrower is a strong credit, are you glad you made this deal? Using our Loan Builder tool, we are able to break down the costs and profit for a particular loan.
The first five steps of our Loan Builder gets us to a risk adjusted offering rate. Since the borrower wants a 4 percent, 5 year balloon loan amortized over 10 years with no prepayment penalty, then we can input those terms and see how the swaps market indicates that structure should be priced. In Step 5, this would be a plug number that would be the amount you make for the credit cost on the loan to get you the 4 percent offering rate.
The remaining steps in our Loan Builder tool outline the costs of making a loan. For this example, Mr. John Doe is a new customer to the bank, therefore we do not allocate any relationship adjustment to his rate. For comparison purposes, Steps 7 through 10 should be the same for each loan deal for your bank. This allows you to compare apples to apples. Steps 7 and 8 are relatively straightforward, as they would be your policy limits you set for your bank. Step 10 is also a simple step, this would be the marginal cost for a similar duration liability to fund your asset. Note, your internal cost of funds is not generally the appropriate rate to use since it does not represent a “marginal” cost of funds. You can use the Libor swaps curve, FHLB advance rate curve, the Treasury curve, or the brokered CD curve. We prefer using the brokered CD curve here as it gives us a true cost of match funding a certain duration asset, plus it is generally lower than the FHLB advance curve, allowing for a competitive rate.
Step 9, although easy to understand, is perhaps more difficult to quantify, the overhead cost of making a loan. This would include personnel expense from your loan officer, as well as the underwriting department and loan review. Other overhead might include compliance costs and costs to keep the lights on. While some of your overhead costs don’t increase as the volume of the loans increase, the incremental cost for booking one loan is fairly negligible from one deal to the next. In the example above, we are assuming this bank has a 2 percent cost of overhead for each loan.
Adjusting for the costs of making and holding a loan, we realize that this competitive loan that walked in the door is only generating a 0.16% percent Return on Equity. If your management and shareholders expect a higher return on their investment, then passing on this particular deal may prove to be more profitable for the bank than booking the loan. Sometimes it makes more sense to buy a lower yielding security as you would have no reserve allocation, a lower capital allocation, and lower overhead expenses associated with purchasing a security. If you can net more than $111 annually by purchasing a 20 percent risk weighted security with a similar duration, you will net more for your shareholders without the credit risk of the loan.
By utilizing our Loan Builder tool that is provided on our new and improved website, www.bancpath.com, you are able to analyze a loan and see its impact to your bottom line. We have created the ability to provide a loan name and printing ability to be able to take some loan pricing detail on a specific loan to your committee meeting and/or keep in the loan file for your customer. If you have additional questions, please feel free to email or call us at amg@bancpath.com or 800.226.1923.