Part Two-Profit Terminology & Margins
In Part one of this series, I talked about “Where Does the Money Come From?” If you missed that, you can read it on our blog at www.fairlendingdiversity.com.
The next piece to the Profit Puzzle is margins. Margins and how they are used in a mortgage company can get incredibly complex. Understanding what they are, who controls them and how they are used to make a profit at all levels of the company is beyond important when explaining your business practices to an examiner. This is especially true if you are attempting to defend your practices for fair lending purposes.
Before we dive into Margins, there are some basic terms you will need to understand. As noted in my first article, I’m breaking this into very simplistic examples so that the concept is learned. As you dig into your own company practices, you will likely see variations on this theme.
Price: Price is the % of the loan amount that the investor is willing to pay for your loan. A price of 100 means they will pay 100% of the amount of the loan. If my company wants to make a profit on the sale, we must charge a higher price to the consumer than what the market is willing to pay my company, or charge the consumer points to make up the difference. Since most consumers do not want to pay points, my company can still charge the borrower no points by simply raising the interest rate offered. NOTE: We are talking about how companies mark up pricing NOT how mortgage originators should mark up pricing-BIG DIFFERENCE!
Interest Rate: The Interest Rate is the rate of interest charged on the mortgage. For instance, a 3.5% interest rate means the borrower is paying 3.5% interest on the money they borrow from you for the term of the loan.
Raw Pricing: Raw pricing is the price the investor is willing to pay for a loan. They offer a “price” with an associated interest rate. We call this “raw price” instead of “price” because it denotes where we are starting from before any “mark ups” or “mark downs” are made to our distribution channel.
Basis Points: Basis point (BPS) refer to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%. When you look at a rate sheet and see a “price” it is the basis points associated with that rate. 101bps would be a price of 101.
Par Pricing: Par pricing = 100bps. At “par” my company pays no money and makes no money. If a lender offers my company a “par price” for my loan, then they are giving me 100% of the value of the loan.
Example: $100,000 mortgage loan = a $100,000 check from the investor for that loan.
Above Par Pricing: Above Par Pricing is anything above 100bps (Par). A price of 101 would be 1% above par. If my company is offered above par pricing, then the investor is willing to pay me a premium for this loan.
Example: $100,000 mortgage loan = a $101,000 check from the investor for that loan. They paid my company 100% of the value ($100,000) plus a premium of 1% ($1000) for a total of $101,000.
Below Par Pricing: Below Par pricing means that the investor is willing to pay my company less than 100% for the loan. Uh Oh! An example of below par pricing is 99.00. This means that the investor will only pay my company 99% of the value of the loan.
Example: $100,000 mortgage loan = a $99,000 check from the investor for that loan. They paid my company 99% of the value ($99,000) which means my company LOST 1% ($1000). Someone is going to get fired!
Now that you understand the basic terminology thrown around in pricing, let’s talk about how margin is added to the investor raw pricing in order to yield income to your company.
Margins are “add-ons” to the cost to produce something. So for instance, if I am a manufacturer of a product, and I sell it to a wholesaler, who is going to distribute that product to stores, we each “add on” what we need in order to make a profit for each of our companies.
Corporate Margin is the money that the company needs to make on the loan or loans in order to pay the bills. Generally, this includes all of the overhead expenses to run the company, in addition to profit. After all, every company must pay expenses and the goal is also to generate a profit!
As the pricing is “marked up” through the supply chain, each part of that supply chain needs to add their profit to the price. Otherwise, when they sell the price/rate to the consumer then that entity will not make any money on the loan. For instance, a regional manager may have staff to manage the region, or a branch manager may have staff to manage a branch. Or, you may be a Wholesale Lender who is re-selling the money to a broker. All of this needs to be considered when adding margin so that the bills of the entire supply chain can be paid.
Just a compliance side note here-A company must be careful about how they structure margin in order to comply with the regulatory guidance.
How Margin Works:
The investor sends the lender a “raw price” that is associated with an interest rate. The investor is the company that will buy the loan from your company. They send you pricing information based on a price/rate combination. Essentially, investors are the manufacturers of the money, i.e. Wells, Citi, Fannie, and many other Secondary market players. Mortgage Bankers do not manufacture money because they are not a depository, as explained in Part One of this series, so they rely on investors buying mortgages that they originate. For our examples, look at the chart below.
Examples: One of my investors will buy a 3.5%, 30-year fixed mortgage from my company for 100% of the note value. This is their “par” price. If our company sends them a $100,000 loan at 3.5% they will pay my company $100,000. Hmmm. That won’t make any income for my company! Their “raw price” had their corporate margin built in, so if I want to make money for my company I need to build in my corporate margin before I advertise that rate. Otherwise, our company loses money!
So, I further look at the pricing from my investor and see that if I offer my distribution channel a rate of 4.0% then my investor will pay me 102% of the note value. This is a 2% premium over the par rate. In this scenario, my company will make $2000 on this loan. Secondary or your pricing engine pick the appropriate price/rate combo and then present that rate at “par” to your origination staff in most scenarios. It does not always work this way so keep reading this series where I discuss loan originator pricing.
My Investor Raw Pricing For Today
Technology and Margins
Most of you have a pricing engine that makes the process of building in margins really simple. When your pricing engine was “configured” your secondary team built in the margins per entity. An entity is a line of business as defined by your company. It tells the engine to group and price all loans in this entity the same way. An entity could be a branch, call center, retail only, wholesale or many other groups. The secondary people look at each line of business, decide on margins and add those to the pricing engine. When the pricing engine pulls in the raw pricing for the day, it adds those margins and then displays the rate and price with the margins already built into it. This not only saves time, but it avoids mistakes and discretion at the level of the originator.
The issue is that many times the pricing engine configuration is out of synch with pricing policy. There is nothing worse than believing that your company is pricing a certain way, you have written policy on that process and then you find out your pricing engine is doing something different!
Stay tuned for Part Three where we take the next step in pricing which is loan originator pricing and risk adjustments!