Question

1. How a lender sets an interest rate on a borrowers loan? Explain

2. Equity Valuation prior to anticipated good and bad earnings announcements. Explain

Answer 1

1. We must understand that the scenario of lending and borrowing money is a business set-up where everybody is there to earn. If there would have been no earnings this business would have never existed. Therefore, considering the basic model of trading where everybody earns by selling products, here everybody earns by selling money at a cost which is known as the borrowing cost or the interest. Now, when you borrow money from banks they give you the funds at a certain interest rate which you have to pay monthly along with you installment. That interest is the cost to you and earning to the bank on the money it lent to you. We must understand how the banks get this money? The funds that banks lend is usually obtained from public at large through the deposits made by them in their savings and current deposits account. However, these deposits also cost to the bank and the cost that bank pays for these is the interest on savings bank account and current bank accounts. Therefore, Naturally to earn profits in this case we need to charge higher from our borrowers as compared to what we pay to the lenders. For example, if a bank pays 6% interest on savings bank account then for the purpose of loans, it must give loans at an interest rate of higher than 6% so that it comes in a position to pay this 6% and earn a suitable profit for itself.

There are many other ecomonic and financial factors that decide the lending rates which are as follows:

1. Prime Lending Rate (PLR) : The prime lending rate is the base rate that is followed by all the banks together. This rate is usually set up by the economic factors of any country/economy and changes in accordance with the annual performance of the economy. if the banks want they can charge above the PLR as per their requirement but, they cannot go below the PLR.
2. Competition: The banks and other lenders also keep in mind the competition in the industry. If the other banks are giving out the funds at a lower interest rate they would not keep their own rate higher to incurr losses. Hence, the market competition also decides the rate at which the money is to be lent.
3. Cost plus pricing: To disburse funds and to run the bank various facilities are used and costs are incurred. In trading when we follow the cost plus model, we price the products as "Material + Labor + Overheads + Profits = Selling Price", likewise the banks and borrowers consider their costs for example loan processing charges, documentation, approvals, salaries etc etc and then fix an interest rate to be charged from the borrowers so the their costs get covered.
4. Credit rating: The banks also check the credit ratings of the borrowers and fix an interest rate. borrowers with a good credit rating (those who have not defaulted in paying off their loans in the past and have a clean defaulter record) usually get consessions or lower interest rate as compared to defaulters and bad credit score borrowers who are usually subjected to higher interest rates or sometimes rejections.
5. Industry / purpose: The interest rate also depends on the purpose or industry in which the loan is given. For example, the rates on agricultural loans is lower due to the government regulations on the interest rates. Similarly the interest rates on a vehicle loan or loans pertaining to luxury items are usually higher.

The above mentioned factors are some of the factors that affect the lender interest rates. However there are many other factors based on situations and cases that can affect the interest rates accordingly.