SA Affordable Housing January - February 2020 // ISSUE: 80 | Page 35

FINANCE MATTERS
and to fulfil every transaction or deal required by its
customers.
The cost of funding as well as infrastructure costs are
collectively known as the hurdle rate. Each product house is
required to achieve the hurdle rate in order for a bank’s treasury
department (which manages a bank’s assets and liabilities) to
allocate finite capital to it, for lending to customers.
This short document aims to explain, in general terms, how
banks determine an interest rate for a loan – including a
mortgage loan.
OVERVIEW OF INPUTS TAKEN INTO
CONSIDERATION WHEN DETERMINING AN
INTEREST RATE
Below are key inputs that considered when determining an
interest rate:
• The term of the Loan
• The loan amount
• The probability that the customer will default – termed
probability of default (PD)
• Once the customer defaults, the loss that the bank will
incur on the loan – termed loss given default (LGD)
• Cost of funding the loan
• Capital required and the cost of holding such capital
(banks are required to retain sufficient capital to meet
depositor requests for the repayment of their deposits
• Any income expected to be received over the term of
the loan
• Interest income
• Any other income (such as fees)
• Any expenses expected over the term of the loan.
HOW DOES A BANK MODEL?
In order to remain viable and to attract depositor and
shareholder funds, a bank has a hurdle rate requirement
that it needs to achieve, termed its return on equity. A
model is used to establish the hurdle rate required for a
portfolio of loans.
The model only considers the projected income and
expenditure over the entire loan term. In other words, the
cost versus the profit of the loan to the bank. The other
factors of the loan, such as the capital and the loan amount
determine the income and expenses of the loan to the bank.
The interest rate is the only factor which can be altered to get
to the hurdle rate requirement. The model therefore keeps all
other factors besides the interest rate constant (this means
the loan amount and term can’t be changed), with the
interest rate varying in order to achieve the hurdle rate.
LOAN AMOUNT AND TERM
Generally, the bigger the loan amount and the longer the
loan term, the lower the interest rate will be. This is because:
• The nett interest rate income received is higher on larger
loans as compared to smaller ones, for example 1% on
R100 000 is R1 000 per annum and 1% on R 1 000 000
is R10 000 per annum;
• The time required for a bank to cover all its fixed costs
and thus achieve the desired return is greater for longer
term loans.
Expenses are not necessarily directly proportional to the
balance of the loan. Only the Cost of Funds and Cost of
Capital would be, everything else stays constant. For
example, the cost of approving and placing a loan on a bank’s
books is say R4 000 per loan, and thereafter the cost of
maintaining a loan on a bank’s books is say R40 per month.
These costs reflect a fixed cost for a bank, irrespective of the
loan amount.
Generally, the interest income generated from a R500  000
loan will be more compared to a R100  000 loan. It follows
Figure 2: Depicting how the interest rate decreases with a higher loan amount for a 240-month loan.
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