Six essential steps for loan-pricing success

How are long-term lending profits built? One well priced loan at a time.

Even when slow and steady progress is the acknowledged goal, pricing loans effectively is no easy feat.

A key ingredient to determining the right pricing for any loan is the prime rate. While the Federal Reserve sets the federal funds target rate, banks set their own prime rates based on the rate established by the Fed.

When the federal funds target rate moves, so inevitably do the prime rates at banks. Generally speaking, the prime rate tends to be “Fed funds plus 3.” So, if the federal funds rate is around 2.5%, as it was in July 2022, then the prime rate would be 5.5%.

Rates have fluctuated dramatically over the past years, even decades. In the early 1980s, for instance, the Federal funds effective rate approached 20%. Between 2010 and 2021, however, the rate never moved far from zero percent.

At the beginning of 2022, inflation began rising and the Fed hiked interest rates several times. On Sept. 21, the Fed raised interest rates three-quarters of a percentage point. The same sized hike that Fed Chair Jerome H. Powell had called an “unusually large one” in June no longer had the power to surprise as inflation in the U.S. showed few signs of improvement. Supersized rate hikes, headlines said, were “the Fed’s new normal.”

The best way to approach loan pricing is to set out a disciplined plan.  Below are the six essential steps for creating and carrying out such a plan:

1. Set quarterly loan yield goals

Before your lending team can rally behind a goal, you have to define that goal for everyone.

In general, quarterly goals seem to work best for loan pricing. That’s because three-month horizons tend to be manageable in size and scope.

Quarterly goals also provide focus, so everyone knows precisely what they’re working towards—and why. What’s more, a quarterly goal allows a team to pivot early when a strategy is not working.

For leaders who may be focused on annual goals, quarterly goals are the equivalent of the four periods in a football game. Even though each quarter matters, it’s possible for a skilled coach to learn from a disappointing score and change the ultimate outcome.

Quarterly goals are powerful, but loan officers will still want to establish milestones to make sure everyone is progressing within any three-month stretch. Milestones should be accompanied by “action items,” or concrete steps to make quarterly goals attainable.

2. Commit to pricing discipline

“Some people regard discipline as a chore,” famous actress and singer Julie Andrews is quoted as saying. “For me it is a kind of order that sets me free to fly.”

“Discipline” could be viewed as the key ingredient that separates “goals” from “accomplishments.” A goal can be a nice-to-have dream for the future. After we begin imagining how to achieve that goal and take the necessary, disciplined steps, the goal holds the promise of becoming a future “accomplishment.”

The difference between “goals” and “accomplishments” is also the difference between realistic thinking and optimism. Too often, lenders pat themselves on the back for having great people and terrific service, believing that customers will pay a premium for those attributes. A bank that possesses a unique magic is terrific, but customers are not always willing to pay for intangibles.

Most bankers understand that too much subjectivity can interfere with pricing loans effectively.

Pricing discipline means taking a realistic perspective, but it also means ensuring adequate compensation for the risks a bank is assuming. Some banks have found that they can pick up an additional five to 10 basis points in interest simply by having a structured pricing methodology in place.

Finally, a sound pricing model prioritizes long-term growth ahead of short-term gain. In other words, a disciplined approach keeps the future in sight at all times. Once a bank is committed to pricing discipline, what matters most is staying the course.

Pricing discipline has many advantages, including that it enables a bank to justify itself if charges of discriminatory pricing were ever raised.

Banking regulators often urge banks to document pricing and underwriting criteria—including exceptions—as a way of demonstrating that their lending practices are fair.

3. Build a loan-pricing model that really works

An effective loan-pricing model incorporates capital into the equation and makes allowances for different levels of risk among borrowers.

It’s important for bankers to slice and dice their credit ratings to make meaningful distinctions. Often, it’s worthwhile to have eight or more categories describing various borrower risk levels. From best to worst, descriptors might range from “highest quality” to “excellent quality,” “good quality,” “acceptable quality,” “minimum acceptable,” “special mention,” “substandard,” and “doubtful.”

Next, it’s important to add daily updated and refreshed Yield Curve (i.e., U.S. Treasury Yield curve or LIBOR Swap curve) data to your pricing model. This ensures that fixed-rate quotes always reflect the latest projected rate trends.

As much as possible, you want to use dynamic models that change when data changes. Think of refreshing Yield Curve data as part of a trend towards rolling forecasts, or financial models that predict the future performance of a business over a continuous period, based on historical data.

In addition, remember that all loans were not created equal; some are more costly to implement and manage than others. Knowing this, you want to make sure that your pricing model takes the cost of originating and servicing a particular loan into consideration.

Finally, it’s important to bear in mind that the loan business does not operate in a vacuum but is part of the overall profitability of a financial institution. Make sure you know your bank’s annual profitability targets, and then price your loans to try to meet or exceed those targets on a loan-by-loan basis.

4. Monitor progress early and often

The best community banks and credit unions are nimble and able to adapt when plans change.

For this reason, it makes sense to assemble the lending team each week to review your progress towards your quarterly goals.

Regular meetings in which employees are held accountable for performance are one hallmark of what’s known as “a culture of performance management.” Too often, leadership can track how an organization is performing against its lending goals, but employees do not have access to the same information.

All goals set should be measurable and there should be mechanisms in place to assess and discuss whatever progress has been made. Meeting on a weekly basis may seem a daunting goal, but it makes success easier to attain.

Say employees are falling short of the loan-pricing targets set. In a scenario like this, managers will want to step in quickly and figure out what obstacles employees are encountering. Managers who remove obstacles—and coach new and different ways to operate— may be able to right the course and meet quarterly goals.

5. Know your competition

“The time your game is most vulnerable is when you’re ahead. Never let up,” says Australian tennis champion Rod Laver.   

If this is true in sports, it’s also true in business. Paying attention to the competition can help you perform better, whether you’re ahead or behind.

For banks, it’s an excellent idea to conduct peer-group analyses, keeping an eye on how your closest competitors are pricing loans. Knowing how other banks and credit unions are pricing their loans can help you review your own criteria and ensure you’re not missing anything major. 

That said, never let other financial institutions sway you from your course without a compelling reason. When in doubt, trust your own analysis for reaching critical pricing decisions.

6. Recognize the wins along the way

Celebrating small wins is an essential part of success. When the small wins that contribute to a large victory are not acknowledged, it’s easy to become discouraged.

Generally speaking, it’s a good idea to celebrate steps towards your loan-pricing goals each and every month.

Even when progress seems slow, it’s important to appreciate the gains that have been made. Remember that slow progress is better than no progress at all, and a steady, disciplined approach will win out in the end.

In conclusion

Although the details change over time, a disciplined, yet agile, approach to loan pricing can help your lending team navigate short-term challenges without losing sight of longer-term, big-picture goals.