How to Price Commercial Loans
Pricing commercial loans is very different from pricing residential financing. The terms, rate structure, appraisals (if real property is involved), payback time frame, and fees are individual lender choices. Pricing is not controlled by secondary market rules, like the mortgage loan industry. Whether one is involved in commercial lending, a broker of commercial loans, or hopes to be the recipient of business financing, understanding how to price commercial loans can be valuable.
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Price Commercial Loans
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Understand that the entire lending universe functions on one primary factor: risk/reward theory. From personal unsecured loans to mortgages to commercial lending, the risk of making the loan and the reward (income) must be balanced. For example, an unsecured personal loan is priced higher than a new car loan. Since auto financing involves having a security interest in the vehicle, the risk of loss is less than an unsecured simple promise to repay in a personal loan.
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Analyze the risk/reward equation, particularly risk, before pricing commercial loans. There are four primary factors in assessing the risk. Evaluate the collateral offered by the business borrower. Real estate is usually more secure than furniture, fixtures, and equipment or inventory. Next, analyze the recent operations of the business. Examine balance sheets along with income and cash flow statements. Then, look at the credit history of the company. Learn how it historically pays its bills and debts. Finally, evaluate the reason for borrowing. If financing is needed to right a "sinking ship" or to grow and expand successful operations, the risk factor may vary widely.
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Decide on an acceptable reward (income) to equal the risk factor. While most income will come from interest payments, there are other ways to help get to the desired bottom line. Points (one point = one percent of loan amount) and fees contribute to income. Offering adjustable rate loans with a rate index (published third party rate), margin (percentage above the index used to set new rates at adjustment dates), and caps (maximum rate increases at adjustment or over the loan life), allow loans to be priced at or under market, with projections that support future increases to keep pace with the market.
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Compare the perceived risk versus the desired reward. Set a start interest rate, adjustment frequency (monthly, quarterly, semi-annually, or annually) to permit rate changes that are fair for both lender and borrower. Decide on a published index, e.g., National Prime Rate as displayed in the Wall Street Journal, and margin above the index to calculate future rate adjustments. Decide on any points and fees needed to reach the income goal established in the prior step.
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Price and offer the commercial loan based on the analysis results. Unlike many other loan products, commercial financing is often negotiated, particularly the terms other than the interest rate, like points, fees, loan term, and other borrower requirements. Should the risk/reward analysis indicate pricing the loan higher than market, there may be some negotiating ability to re-price the offer.
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