How To Calculate The Return On Loan

How does the bank calculate my loan interest?

The question of the amount of interest is one of the most important when borrowing money, be it to fulfill one's own dreams or to cope with a difficult life situation. This article aims to shed some light on how banks calculate your interest rate.

The lending rates consist of different components

Quite simply, the loan interest is calculated like the selling price of any other product. In other words, when it comes to the interest rate, in simple terms, we can speak of a price that the borrower has to pay in order to receive money from the bank that is the seller. Therefore, the determination of the interest rate from the customer's point of view begins with the purchase price of the money for banks.

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The reference interest rate as a basis

Many loans, such as the mortgage loan, are tied to a reference interest rate to which the bank adds a premium. Usually the EURIBOR is used for this (more on this in "Who is the Euribor?") This indicates how much interest the bank would have to pay to other banks in order to borrow money for a certain period of time. In a figurative sense, we can speak of the purchase price (purchase interest rate) here.

An interest rate is now added to the reference or base interest rate, in the above case the EURIBOR, which consists of various components:

1. Surcharge for risk costs (standard risk costs)

From time to time it happens that borrowers are unable to repay their loan or loan. This causes costs that the bank has to earn in order not to become insolvent. One also speaks here of the expected loss. This is where the rating or the assessment of the creditworthiness of the borrower and possible collateral come into play (here you can find out how you as a corporate customer can improve your creditworthiness and your rating). For this purpose, the bank divides all customers into certain classes in the course of a rating process and uses statistical methods to determine the probability of default for the respective risk class. This probability of default is then packed into the interest rate as a percentage risk premium.

The better the credit rating, also known as the creditworthiness, the lower the risk premium. Securing the loan, for example through a mortgage (mortgage security through entry in the land register), through surety, through pledging of savings or securities balances or insurance can significantly reduce the bank's risk again and lead to a lower risk premium.

In summary, the risk premium is usually the largest expense item for borrowers. From the point of view of the banks, it is necessary to calculate the risk associated with loans strictly, otherwise they can get into serious difficulties, which ultimately affects the entire economy. See Hypo Group Alpe Adria AG as a negative example of this.

2. Cost of Equity

To put it very simply, these are the costs that the bank incurs as a result of laws (Basel II and Basel III) having to reserve a certain percentage of the loan amount in cash for each loan. As a result, the bank incurs opportunity costs (it misses out on possible profits), which it must earn.

The sense and purpose of these legal provisions is that in the event of an emergency, such as the last banking crisis in 2008, this capital is intended to absorb losses that can arise beyond the normal risk costs. One speaks here of the cost of the unexpected loss.

3. Attributable operating and material costs

Every lending process generates completely normal costs at the bank, such as those that any handicraft business would have when providing its services, such as costs for personnel and materials. This begins with the conversation with the bank advisor and leads to the back office of the bank, where all documents are checked and managed. Material costs are, for example, costs for materials used. These costs are also converted into a percentage and form part of the credit surcharge.

4. Costs that are not directly attributable (overhead costs)

These are costs that are not directly attributable to the loan agreement, but arise in order to be able to maintain the operation as a whole. Examples of this are costs for management, accounting, IT infrastructure, etc. These are added to each business as costs using a conversion key, as these ultimately have to be earned.

5. Profit mark-up

Since points 1 - 4 are seen as pure costs for the bank, the bank now wants to earn something. This is made possible by the profit mark-up (margin). This profit wish is in turn packed into the interest premium in the form of a percentage.

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As you can see, the pricing of a loan works essentially the same as the pricing of everyday consumer goods or other services. The only exception are the risk costs associated with lending money.

Reference interest rate + surcharge for risk costs (standard risk costs) + equity costs + attributable operating and material costs + costs not directly attributable + profit surcharge = loan interest

Of course, this representation is a simplification of reality and each bank will represent or name certain points in a slightly different form. However, this does not change anything essential in terms of content.

Important for borrowers: Try to improve your creditworthiness or the security of your financing. The best way to do this is to read our article Improving creditworthiness and saving loan interest. These are the only options for you to actively negotiate better terms.

Make sure that you choose a realistic monthly loan installment that you can pay off every month. The monthly rate depends on the term, the loan amount and the interest rate. Calculate different scenarios with our loan calculator - so you can easily see how much credit you can afford.

The remaining factors depend on the bank and can of course vary from one institute to another. The more efficiently a bank works, the lower the operating, material and overhead costs will be.

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