How do banks calculate the interest rate?

So many people would like to know how a credit rate is set. Why do some get better rates than others? Why do some organizations offer cheap credit and others are higher? We will explain all the mechanisms involved in determining a credit rate.

Need to set the rate of a credit to be profitable

A lending organization of any kind is not a not-for-profit business. A credit, although intangible service, must not be offered at a loss. Credit agencies or banks calculate the consumer credit rate in such a way as to reach a certain break-even point.

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Calculation of profitability of a financial organization

Credit agencies or institutions lenders determine their earnings and costs before establishing the rate of a credit.

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Earnings

For a credit organization, the earnings associated with a credit are as follows:

  • file fees
  • interest received on credit related to the credit rate
  • interest collected on credit insurance
  • possible prepayment and/or outstanding charges during the life of the contract

From a customer point of view, the financial organization’s gain corresponds to the cost of credit and insurance to the client. This credit cost can be easily calculated using the APR rate, which incorporates all charges for a consumer credit. The cost of insurance can be calculated using the TAEA.

For a real estate loan, we also talk about APR. Even if insurance is compulsory, the Hamon Act of 17 March 2014 allows the borrower does not necessarily choose that of the lending agency. We therefore go on the same conditions as conso credit to determine the cost and margin of the loan.

Costs

In order to properly set the rate of a credit, it is essential to quantify the costs well. The latter are of three orders:

Operating and marketing costs

Behind all the rates of a credit, there is a business. In order to make the latter live, there are all the costs associated with its proper functioning: staff costs, structure costs, etc. In addition to these costs, there are also all costs related to commercial investments in order to publicize the product, such as advertising.

The cost of refinancing

Surprisingly, all credit agencies and bankers borrow money on a specific market in order to be able to lend the money. This loan has a cost that is called the refinancing rate . The value of this rate depends on the market situation, the duration of the borrowing but also on the financial health or rather the financial soundness of the borrowing financial organization.

For this reason, the majority of specialized credit agencies are subsidiaries of large banking groups. Cetelem is the subsidiary of BNP Paribas, Sofinco is the subsidiary of Crédit Agricole, Cofidis is the subsidiary of the Crédit Mutuel-CIC group and Franfinance the Société Générale. On the French market, only Oney and Carrefour Banque are not directly subsidiaries of large banking groups. The former is a subsidiary of Auchan and the second is the subsidiary of the eponymous group.

We can therefore assume that Sofinco, for example, gets a lower refinancing rate than Banque Accord given the much more substantial equity of Crédit Agricole (the first bank of individuals in terms of savings). So one could expect that the rate of a Sofinco credit would be cheaper than Oney’s. And yet, it’s not so simple.

The risk of non-repayment of loans

This cost is most noticeable when deciding to offer a low or higher rate credit. Indeed, the less a client will repay his credit, the more he will create losses for the credit organization . However, these losses will have to be caught up. And how can we make up for losses when you’re a financial company? Very often by increasing the credit rate of new loans…

And if many customers start to no longer repay their credits, it is the risk of bankruptcy for the credit company.

Rate of a credit: the cost-effectiveness

No need to be an accountant to understand that earnings must be higher than estimated costs . The financial departments of the credit bodies thus calculate the minimum interest rate that can be proposed for a credit according to its nature (project, amount, duration). The rate of a proposed maximum credit is legally set by the Banque de France and is called the rate of wear and tear, we will return thereafter.

The banks’ executives therefore take over to establish the rate of loans actually offered to customers, which incorporates the company’s margin. The offers offered in terms of rates are also regularly renewed in specialized credit organizations such as Cetelem, Sofinco, Carrefour Banque, Younited Crédit, Cofidis who are fighting mercilessly to offer the best credit, at the lowest rate. Each one has his specialties (projects, amount, duration) and can therefore draw his pin from the game. It is essential to compare at a moment T in order to get the best credit . It is on these bases that we have developed a comparator to classify offers permanently.

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Case of credit rates at 0%

Despite all these explanations on the calculation of the rate of a credit, a question may arise. Why do we sometimes see zero-rate credit offers flourishing? In general, three families of 0% credit co-exist:

Loan at 0% rate acronym PTZ. It is a state-subsidized loan that is accessible under certain conditions This credit is also named by its (purchase of real estate, resource conditions, etc.) to a neo-owner. It is limited in amount and is therefore generally associated with conventional real estate credit. It is a government measure, and therefore it is not intended to be profitable.

Free in-store credithidden defect and the client will not pay interest on this loan. Credit interest is borne by the store This type of loan is regularly offered in retail retailers. There is no . The brand offers this free credit offer in order to facilitate the sale of the property. In general, this type of credit is offered for a small period (3 or 4 months) and requires regular payment of the first monthly payment by credit card at the time of purchase in order to ensure that the customer is well solvent.

Auto credit 0%this credit is not necessarily of the most interesting This is the same principle as 0% in-store credit, it’s the car manufacturer, see the dealer automobile that pays interest. The customer therefore pays no interest on the proposed 0% auto credit. Nevertheless for the car buyer. Indeed, when buying a car, the seller regularly makes a significant reduction on the price of the car, especially if it is new or recent. In the case of a proposal for a 0% credit offer, the seller is unlikely to be willing to offer a nice discount on the sale price.

The buyer will thus have every interest in minimizing the overall cost of the transaction: vehicle price credit cost. For this, most of the time, the optimal solution is initially to negotiate the price of the car and in parallel to finding the cheapest car credit.

Risks related to a credit rate

Bankruptcy of a

As certain costs are easily identifiable, good risk management is crucialcredit for a lending organization. Poor anticipation of the risk of non-repayment can cause the company to bankruptcy. Indeed, it is easy to understand that if a company grants €10,000 credit and it does not have any refund in return, this will be a problem.

Especially if this phenomenon occurs over several credits. Credit companies are making every effort to control a future risk that could jeopardize it. It is therefore necessary to:

  • Detect those who will not be able to repay as well as possible fraud in order to decide whether or not to lend them the money.
  • Anticipate future risk and calculate its cost.
  • Implement all measures in order to recover the money loaned. Directions recovery and/or specialized entities have often been established to address this issue.

Some companies have paid for their mismanagement of risks.

Access to credit is not open to all

Unlike other countries, France has a safeguard: the rate of wear and tear. In France, any lender organization is obliged to lend the money at credit rates below the rate of wear which corresponds to the maximum rate not to be exceeded. We must also talk about the rate of wear in the plural, because there are several depending on the product and the amount remaining to be reimbursed. These rates avoid possible drifts.

Here are some wear rates applicable in Q2 2018:

  • Consumer credit For a loan less than the EUR 3000 credit, wear rate: 21,07% Regarding a credit included between 3000€ and 6000€: 12,99% For an amount greater than the €6000 credit: 5,89%
  • Real estate credit Fixed rate loan less than 10 years: 3% Fixed rate loan with 10-20 year repayment term: 3.03% Variable Rate Credit: 2.69%

By obligation, the lending agency will have to set a credit rate below the rate of wear.

These rates of wear also imply that many French people do not have access to credit because they are considered too risky by credit agencies. As the latter cannot practice a rate too high to protect themselves from the risk of certain cases, they prefer to refuse them. In the end, less than one consumer credit applicant in two is pre-accepted by at least one credit agency . Indeed, we have developed a credit comparator with real-time response in principle. And it’s what we are seeing.

Therefore, a large segment of the population does not have access to credit. Is that a better situation than having exorbitant rates? For example, in the United States or the United Kingdom, some rates can reach from 30% to 40%

Differences in rates depending on the need?

How is the rate of a real estate credit set?

The rates of a real estate credit, whether fixed or variable, are rather low during this period . They are indexed to refinancing rates. Fixed-rate loans are based on the 10-year OAT benchmark index. Loans at variable rates are indexed to EURIBOR. The rates of a real estate credit are lower than those of a consumer credit because the repayment period is much longer. In addition, in case of non-refund characterized by the borrower, the lending agency is entitled to seize the house. According to the Banque de France, the average housing credit rate is 1.61% in February 2018.

How is the rate of a consumer credit

Although the methodology remains the same for setting the rate of a credit, the actual APR rates are quite different from one product to another . The rates of the personal loan or any other conso credit shall be determined according to the risk induced. Where the borrower provides a justification for the use of the funds, whether for the purchase of a vehicle or carrying out work, the proposed interest rates are generally lower than when no justification is provided.

A different risk for each credit

For car credit, the risk is all the lower as it is possible to grab the car. On the contrary, for personal credit, car credit rates are higher because the risk of non-repayment is higher. The proposed interest rate is even very close to the rate of wear when it comes to a small credit. The product offered for an amount less than 4000€ is the revolving credit. The rates of this described product regularly reach 20%.

The last product in the category of consumer credits , the consolidation of credits. For this product, the rate of a credit is also close to the rate of wear because the primary objective of the borrower is not the value of the rate itself but is to reduce their monthly payment. Credit agencies have understood this well and are not fighting a hard battle over rates. It then becomes easier to set the rate of this type of ready.

The rate set differently depending on the duration of repayment

In order to attract a new borrower, one of the preferred lines of communication for credit organizations is to communicate about the small rate of a credit. For this, many communicate on very low rates of the order of 1% (we have even seen 0.8%). However, with such a low rate and if the borrower does not subscribe to borrower insurance, the lending organization will find it difficult to be profitable. That is why this rate is just a catch . It is offered only for 12 months. To benefit from this rate hook, the borrower will therefore have to repay a very important monthly payment, which will put off the majority.

As of 17/04/2018, here is a typical example of a rate hook that will shed light on our remarks:

Bank Casino displays a personal credit rate at 1.00%, but this rate is only available for a €15,000 credit over a 12-month refund period. The resulting monthly payment is 1256.75€ without insurance. This monthly payment is therefore not open to all scholarships and very few borrowers will actually get this rate. In view of this example, the APR is not the only determining criterion when choosing a loan, the monthly payment in line with its ability to repay is also to be taken into account.

The rate of a credit depends on the potential risk of the borrower

Some credit agencies adjust the rates of the proposed loans according to the potential risk of the borrower. In order to identify this potential risk, the lending agency is based on statistics. It assesses how a new borrower looks like a former borrower. For example, if the borrowers “owners” have better repaid their credits as the “tenants”, the financial agency could agree to offer a lower rate to landlords.

All the requested information can be used to differentiate one profile from another. The credit company thus builds a non-repayment risk score that assigns to each credit application a rating. The rate of a credit actually proposed at the end of the application for credit may therefore be different from that shown at the beginning. In order to compensate for this lack of communication, credit agencies thus communicate on “a rate from”.

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