Money Mentor: understanding the mechanics of loan pricing

Question: I have a loan out at the minute for a shed that I built two years ago. There are still eight years left on the loan, and I’ve been keeping up to date with payments and haven’t missed any.

So, in theory, all’s going well. However, my bank has just notified me that my loan repayments are due to increase for the second time.

I know the market has seen rising interest rates recently, but my neighbour, who has a similar loan with a different bank, hasn’t seen any increases.

I’m wondering why this might be and what I should know about loans going forward so that I can make better decisions for my bottom line?

Answer: This is a great question, as while today’s farmers face a multitude of challenges, managing farm finances is front and centre for most.

Loan repayments, in particular, can have a significant impact on financial stability.

One crucial aspect of financial management is understanding the base cost of any bank loan, a factor that can significantly impact your repayments and, ultimately, your bottom line.

Whether your base cost is tied to Euribor, the Bank’s Cost of Funds, or a standard variable rate loan, knowing the fundamentals is key to making informed financial decisions.

If you’re not familiar with these terms, don’t worry, we’re going to delve into each one of them now to explain the implications of each.

Euribor Loans

One commonly used benchmark for interest rates is Euribor (Euro Interbank Offered Rate). This rate reflects the average interest rates at which Eurozone banks lend to each other and is often used as a reference point for variable-rate loans.

Euribor is often confused with the interest rates set by the European Central Bank (ECB), but they actually operate independently of each other. The ECB’s monetary policy influences liquidity in the interbank market, which indirectly impacts Euribor rates.

However, the ECB lacks direct control over Euribor, as these rates are determined by market forces (supply and demand) among commercial banks. This is distinct from the ECB’s direct influence on rates that apply to transactions between individual banks and the ECB itself.

Bank Cost of Funds

Your bank may tie their loan base to the Bank’s Cost of Funds, so understanding this is equally vital. This metric represents the average cost a bank incurs to borrow money, including interest paid to depositors and other financial institutions.

Monitoring changes in this cost can provide you with insight into potential shifts in loan interest rates, which can help you to plan for changes in loan repayment amounts.

Standard Rate Variable Loans

These loans are usually for lending amounts up to c.€300,000. Your bank sets the rate attached based on its costs of accessing the required funds and adding a margin.

These loans are not tied to Euribor but may be influenced by it, and movements to the rate in these loans are relatively infrequent.

While it might sound like a bit of a chore, it’s well worth your while being well-informed about the pricing mechanisms that your financial institution is using, especially in light of the current market dynamics.

As European markets experience some volatility, the gap between the all-inclusive rates offered by Irish banks has widened. You’re seeing real-world proof of this in the difference between your own repayments and your neighbour’s.

To make informed decisions that protect your bottom line as much as possible, all farmers should understand the base lending rates used by their banks, as this forms the foundation of their loan agreements.

Let’s put this theory into practice with an example. Consider the table below showing Bank A, Bank B, and Bank C, each employing different base lending rates – a 3-Month Euribor with Bank A, Bank Cost of Funds (BCOF) with Bank B, and Standard Variable Rate with Bank C.

Example of different lending rates

The quoted bank margin, as specified in the loan Letter of Offer, is then added to the base lending rate to give the all-inclusive interest rate that the lender will actually charge you.

You can see that there’s a significant difference between the three banks in the final, all-inclusive interest rate paid by the borrower. You need to know both your bank’s base lending rate and their quoted bank margin to get the full picture.

Understanding these kinds of details will empower you to make informed financial decisions and effectively navigate the current market challenges, which are very real and can have a significant impact on finances.

In summary, always remember that it goes beyond just negotiating and agreeing on the bank’s margin—the ultimate determinant of your business’s annual loan repayments is the bottom-line interest rate.

Therefore, a thorough understanding of base lending rates and the quoted bank margin is essential for ensuring your farm’s financial viability and sustainability.

We hope the shed loan continues to run well for you and we hope this deep dive into loan pricing helps with future decision-making.

Understand the base: Loan repayments vary based on the bank’s base rates, which can be Euribor, the bank’s cost of funds, or a standard variable rate.

Market Impact: Market volatility and different bank costs can lead to varying loan repayments, as shown by the example of different banks’ base rates and margins.

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