Lending Perspectives: Adopting a Marginal Pricing Mindset

Ed Baranowski, retired CEO of Fairwinds Credit Union, used to lament 25 years ago about “stupid competition.” Trying to meet stupid competition is rarely profitable. Today we’re faced with some desperate competition, as there is a flood of liquidity in the financial system. Virtually every bank and credit union needs more loans now! But how can they get them profitably?

Over the last few months, I’ve explored ideas for credit unions to successfully increase their loan volume. Last month I promised a process to sharpen your pricing pencil while increasing the profitability of your credit union. After all, not all pricing decisions to make more loans result in additional income.

A Process for Sharpening Your Pricing Pencil

Over 20 years ago, when faced with the challenge of making more loans through lower rates, I questioned whether I would generate more income for the credit union. Lowering rates should generate more loans, but what about more interest income? How do I factor in the cost of doing additional lending?

Making more loans generates costs that the alternative to lending—investing—doesn’t. Those costs can be credit losses, additional employee expenses including incentives and overtime, and the margin you need to make over investment rates. (For economic geeks like me, the rate you make on investments is your opportunity cost.)

For the sake of brevity, after a lot of back-of-the-napkin math and testing of my understanding of how economics applies to loan pricing, I came up with a simple formula to determine the breakeven point of lowering your loan rates to drive volume—in essence, a way to determine the minimum amount of additional volume needed to generate the same income. But the only reason to make more loans is to make marginal (additional) income, so this breakeven calculation should be considered a starting point.

My marginal pricing model looks like this:

If you think of the model in a very simplified way, the numerator (rate reduction) is what you’re giving up in lowering rates on your existing volume. The denominator is what you’ll net on the margin in making the additional loans.

Let’s consider a hypothetical but realistic example: ABC Credit Union is currently charging 3.25% on a new car, A+-tier, 60-month indirect loans. It is considering a rate of 2.75% to pump up volume and would like lower rates across the board. The CU pays the dealer an average of 1.5% of the loan amount for the business. The CU’s loss experience shows that a 60-month, A+-tier borrower has less than 5 basis points (.05%) annual loan losses. ABC CU has also determined it can handle additional business without having to hire more staff and would need almost no overtime to meet the goal of additional loans. The CU is currently making 60 basis points (.60%) when investing its new excess funds. Here’s what the numbers look like in the formula:

… or .50%/1.35% = 37.04%.

If ABC CU is currently making $10 million total a month in indirect loans, it would have to increase volume to about $13.7 million just to break even. Its goal probably should be closer to $15 million to generate some nice returns.

Deciding Whether to Move Rates

Last month I touched on the concept of elasticity of demand as it pertains to pricing loans and consumer demand. Understanding that concept is critical when deciding to move rates. In today’s environment with 0% financing from car manufacturers—not to mention a fair share of other irrational pricing in the marketplace as there is a flood of liquidity in the financial system—there’s no guarantee moving rates will drive enough volume. You might decide that a strategy to lower rates across the board might not make sense. While chasing A+, new car volume for 60-month loans may not work, lowering rates for 84-month new car loans or for most used cars might drive enough volume to generate marginal income.

There are some other things to understand about this model. I typically start with the shortest-term, highest credit tier in order to evaluate the results. How I price longer-term loans and lower credit tiers is all a function of incremental credit costs and how much more we should earn by lending money at 84 months instead of 60 months. Additionally, if your credit union is smaller, you have different investment opportunities. You may not have the option of buying investments in a block of $10 million, so your investment rate opportunity in turning an extra $1 million a month into loans might look like an overnight rate.

Finally, to have the correct mindset, you need a healthy dose of discipline. If you decide to lower rates to generate volume and you don’t get it, you must increase rates back to where they were. Like I said, the only real reason to make more loans is to generate more income for the credit union, so if your rate changes don’t drive enough additional volume, you must have the discipline to revert back to your prior rates.

CUES member Bill Vogeney is chief revenue officer and self-professed lending geek at $8 billion Ent Credit Union, Colorado Springs.