Question

Assume a bank’s review of its historical loan losses has been estimated at 1.33% for its auto loans. The bank currently has gross auto loans of $2,000,000. If the bank determines that the optimal or desired rate (r) for its auto loans is 4.5%, what rate should it charge to compensate for its expected losses?

Answer 1

Considering the historical auto loan loss of 1.33%, if current gross auto loans are $2,000,000 then expected loss will be $26,600 i.e. 1.33% of total loan. Now the bank want to charge interest rate to compensate this loss also. If optimal rate for auto loan is 4.5% then on loan of $2,000,000 comes out to be $90,000. The loss of $26600 shows that auto loan which will be recovered will be $1,973,400. To cover total interest amount of $90,000 and loss $26,600 i.e. $116600 the rate should 5.908% i.e. (116600/1973400).