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   ARTICLE   |   From Scotsman Guide Residential Edition   |   June 2017

The Secrets of Mortgage Pricing

Learning the language of the secondary market is still important

For many originators today, mortgage pricing has always been automated and presented to them by their company’s pricing engine. Older originators may remember the days when lines of fax machines pumped out rate sheets all day, and they had to figure out pricing for themselves. Not only did this take a lot of time, but it resulted in a lot of errors. Whichever world you come from, understanding how mortgage pricing gets created is an important skill to learn.

Basic mortgage jargon can take years for novices to understand. Understanding how pricing works makes that learning curve even steeper. It is another language and one that is not easily grasped.

Not understanding the language and concepts can cost you deals, however. The ability to discuss pricing structures also is important for making the right decision when interviewing with prospective employers.

Where money comes from

Mortgage companies do not manufacture money because they are not depositories. They don’t have customers opening up checking and savings accounts or adding money to certificates of deposit. Their business model is to set up a warehouse line from which they can fund their mortgage closings.

This warehouse line comes from a bank and works like a credit line. The company funds a mortgage loan, an investor buys the loan after closing, which then pays back the warehouse line so the next mortgage can be funded. This cycle can occur hundreds of time per day.

Financial institutions that accept depositor funds, like banks, may have varying models for funding mortgage loans. One option is to use the funds of depositors and offer mortgages or other loans to consumers or other institutions.

When those loans get paid back, they produce profit for the bank in the form of interest. If a bank pays depositors 1 percent on their deposits, for example, and the interest the bank collects on a mortgage is 4 percent, this leaves the bank with a 3 percent spread, or income stream.

Another option exercised by banks is to borrow money from the Federal Reserve. The “cost of funds” index is the rate at which financial institutions can borrow money. Banks can borrow at that rate and offer money to consumers or other entities at a higher interest rate to make a profit on the difference between the two rates. Banks even may make use of both models at once. Large banking institutions like Citibank, Chase Bank, Wells Fargo and Bank of America use these models and more to make a profit.

Secondary markets

Secondary markets are the money people that purchase loans from mortgage companies. They do not deal with borrowers directly, but they do want to make money from the transaction and are willing to take on the risk of the borrower paying them back. Whereas primary market people — banks that do not carry the debt and mortgage companies — want to work directly with borrowers, but do not want to take on the risk associated with those borrowers paying them back.

There are many secondary market players. These secondary market players include Fannie Mae and Freddie Mac — the government-sponsored enterprises — as well as pension funds, insurance companies and many others. Some lenders, like the big banks, are both primary and secondary market players.

Corporate margin is the money mortgage companies need to make on loans to pay the bills needed to run the company and turn a profit.

Obviously, in a two-tiered system like this, companies in both tiers need to make a profit or the whole system will collapse. The important piece of this profit puzzle is margins, an age-old concept used in numerous industries. The use of margins in the mortgage industry, however, can get incredibly complex. Before we dive into the topic, it is important to understand some basic terms.

  • Price: This is the percent of the loan amount that investors are willing to purchase. A price of 100 means the investor will pay 100 percent of the loan amount. If the mortgage company wants to make a profit on the loan, they must charge a higher price to the consumer than what the secondary market is willing to pay for that loan, or charge borrowers points to make up the difference. Most borrowers do not want to pay points, so mortgage companies typically raise the interest rate offered. (Note: this is how companies mark up the pricing, not how mortgage originators should mark up the pricing.)
  • Raw price: This is the price that investors are willing to pay for a loan. Typically, they offer a price (as above) along with an associated interest rate. This is called the raw price instead of price because it denotes the starting point before any mark-ups or mark-downs are made to a company’s distribution channels.
  • Basis points (bps): This is a common unit of measure for interest rates. It is equal to one one-hundredth of one percentage point.
  • Par pricing: Pricing is measured on a scale with par equaling 100. At par a lender pays no money and makes no money. When originators offer borrowers par price for their loans, the borrowers pay no points — with one point equaling 1 percent of the loan amount — and get no lender credit. If mortgage companies have raw par pricing from investors, they must mark up the pricing by increasing the interest rate to make a profit before they offer par pricing to borrowers. 
  • Above par pricing: This is anything above 100. A price of 101 would be 1 percent of the loan amount above par. If a lender is offered above-par pricing, then the investor is willing to pay the lender a premium for this loan. When a mortgage company gives a borrower above-par pricing, most pass on that premium to the borrower as a lender credit to help offset closing costs — normally in exchange for a higher interest rate.
  • Below par pricing: This is when an investor is not willing to pay a lender 100 percent for the loan. A price of 99, for example, means the investor will only pay the lender 99 percent of the value of the loan. Borrowers would then need to pay 1 percent of the loan amount, or one point, to get the lower rate at the par price. This is referred to as a discount point because the borrower is paying to discount the interest rate.

Margins

Now that we have some of the basic terminology out of the way, let’s discuss how margins are added to investor raw pricing to yield income for a mortgage company. Margins in any industry are simply add-ons to the cost to produce something. Product manufacturers, for example, sell their wares to wholesalers, who then distribute that product to stores. As the pricing gets marked up through the supply chain, each part of that chain needs to add their profit to the price.

Corporate margin is the money mortgage companies need to make on loans to pay the bills needed to run the company and turn a profit. Otherwise, when they sell the price, or rate, to the borrower, that company will not make any money on the loan.

Regional offices have staffs to manage a national mortgage company’s region, for example. Mortgage branches have overhead costs and staff as well. Even wholesale lenders, who resell money to brokers, must pay overhead and try to make a profit. All of these offices need to be considered when adding margins so the bills of the entire supply chain can be paid.

Today, most mortgage companies have pricing engines that make the process of building in margins simple. These engines are configured by the secondary market teams to build in all of the margins per entity, which is any line of business as defined by the company. An entity could be a branch or call center. It could be retail only, or wholesale or include many other groups. Configuration tells the engine to group and price all loans within an entity the same way.

The secondary market team will look at each line of business, decide on margins and add those to the pricing engine. The team also must be careful about how they structure the margins to make sure the company complies with all regulatory guidance regarding pricing. When the pricing engine pulls in raw pricing for the day, it adds those margins and then displays the rate and price with the margins already built in. This saves time for originators and helps to avoid many mistakes. 


 


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