Credit Unions - I need to reduce my Interest Rates is this a wise move?

Pricing your products can be difficult however reducing prices can have a dramatic effect on Credit Unions and sometimes due to high liquidity they feel like it is their only option in a competitive market. There is also the perception that this will bring in new members, which it will, but how many new members will you need to generate to achieve the same level of profits?

Let’s take an example

We have a Credit Union , CU Ltd, which has the following numbers:

CU Ltd

Key Numbers

Loans

2,500,000

Cash

500,000

Interest on Loans

500,000

Cost of Loans

300,000

GP%

40%

Overheads

150,000

Reserves b/fwd

100,000

Reserves for year

50,000

Net Reserves

150,000

CA Ratio

5%


CU Ltd is operating just at the minimum level for its size in terms of capital and is making 40% gross margin on the loans. Liquidity is healthy due to high levels of cash. Interest rates are charged at 20% on all loans.

Reduce Interest Rates

If CU Ltd reduces rates by 20% and this enables the business to obtain 20% more in loans from new members what happens to the net profit position and capital adequacy.

CU Ltd

Key Numbers

Reduce interest rates by 20% Increase loans by 20%

Loans

2,500,000

3,000,000

Cash

500,000

0

Interest on Loans

500,000

480,000

Cost of Loans

300,000

360,000

GP%

40%

25%

Overheads

150,000

150,000

Reserves b/fwd

100,000

100,000

Reserves for year

50,000

(30,000)

Net Reserves

150,000

70,000

CA Ratio

5%

2.33%


As you will see the current position has changed first by cutting prices by 20% means interest rates have dropped to 16% from 20% and therefore reduces income from £500,000 to £480,000.

Reduction in profit….

With 20% more customers’ direct costs increase by 20% from £300,000 to £360,000. That’s £60,000 increase in direct costs and this reduces profit by £80,000 overall from the original position to generate a loss of £30,000.

CU Ltd would need to generate new loans of £5 million in total to get the profit figure back to what it was originallya 100% increase!! This is £800,000 in interest at 25% to generate the same gross margin as before. How much time and effort is needed to generate this and realistically would you be able to generate so many new loans from new customers? There is also the cash availability which would be needed to generate the additional loans and the collapse of the capital adequacy; this credit union would struggle to survive for very long without significant funding.

The example is very basic but the message is clear always consider what consequences reducing prices may have on profitability.  There is also the impact of delinquency which isn’t considered here nor is the impact on liquidity which would be a major issue

How can interest rate reductions be managed better

  • Be selective if you are considering a loan sale – do not do it on the whole loan book
  • Having cash isn’t a bad thing even if the liquidity is high. It is easier to control a credit union’s finances with higher liquidity than trying to manage a loss making, low capital adequacy model.
  • Understand your loan book and the different products. Replacing a high interest rate product with a lower interest rate product will impact on profits, as in the example. Try to make any loan sale a small proportion of the loan book
  • Understand how the cost of the loan is made up. There might be inefficiencies here to not only help with lower rates but just as an overall efficiency exercise.
  • Model the impact of loan sales to see how it will impact on the overall numbers before making the decision to go ahead.
  • Keep to your loan policy in terms of vetting the member
  • Seek professional advice if you are unsure

If you wish to look at pricing in more detail for your credit union speak to:

Philip Jones at Hallidays on O161 476 8276

www.hallidays.co.uk/services/specialisms/credit-unions

Posted 28th May 2015

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