How much will the bank need to charge on its loan to make a profit?

Answer 1

The breakeven amount for a particular loan varies from bank-to-bank and customer-to-customer. To give an example, we will use a basic installment loan that is taken from an average consumer.

Say an existing customer takes a personal loan for $3,000 and the loan will last for twelve (12) months. The company has to account for the following MARGINAL elements in order to make a profit:

* Acquisition costs (how much did it cost to acquire the customer)

* Cost of funds (how much do they pay to borrow money that they will loan)

* Charge-off Rate (what is the rate of default for a similar average customer)

* Underwriting costs (how much does it cost to underwrite the loan)

* Onboarding costs (how much does it cost to setup the account)

* Servicing costs (how much does it cost to send statements, take payments, report to the credit bureau, etc.)

* Payoff costs (how much does it cost to close the loan)

Making assumptions for each of the items on a marginal basis:

* Acquisition costs are $0 (we stated that the borrower was already a customer)

* Cost of funds is 2%, or $60

* Charge-off rate is 5% (or $150)

* Underwriting costs are $40

* Onboarding costs are $30

* Servicing costs for 12 months at $2/month is $24

* Payoff costs are $10

So, the basic marginal expense is $164 if we ignore chargeoffs. We will assume that the client does not chargeoff, so the rate needed to break even is:

$164 / $3000 = 5.47%

However, on average, 5% of customers DO chargeoff, so to account for that we might add $150 to the costs as follows:

$314 / $3000 = 10.47%

Most banks want to earn 1% on the asset side and 1% on the liability side, so the bank would likely price the loan at 11.49% or 11.99% for a "good risk" customer.