In This Article
- Introduction to the Cost of Funds
- Bonds: Price and Yield
- Government Bonds, T-Bills
- Setting the Rate Understanding the Cost of Funds
- Other Indexes
- We Can Help
INTRODUCTION TO THE COST OF FUNDS
A lender’s primary source of profit is the interest charged on its loans. These rates vary greatly from loan to loan, based on the loan type, the loan structure, and the time that the loan was closed.
To understand how the factors that affect interest rates and the cost of funds, you must first become familiar with the fundamentals of financing:
- Where do the lenders get the money they lend?
- How much do they pay for it?
- What is their profit margin?
- How is it set?
This blog starts from the origin of the cost of funds in the general financing market and shows how these costs filter down to the individual mortgage loan.
BONDS: PRICE AND YIELD
A company seeking to raise capital may offer (or ‘float’) stocks or bonds to the public for sale. Stocks are shares in the ownership of the company. A stockholder has an actual claim on a portion of the corporation’s earnings and assets. On the other hand, bonds do not represent any ownership in the corporation. For example, one who buys bonds is investing in the company by lending the company the value of the bond in return for a ‘yield’ paid by the corporation when the bond matures, in addition to the value of the bond. ‘Yield’ is the return on investment of the bond and is similar to the interest rate on a loan. For example, a bond priced at $100, which matures at $110, yields 10%.
The yield of a bond is measured as a percentage of its price. Therefore, the yield and the price of the bond have an inverse relationship. As the price of a bond rises, its yield falls; as the price falls, its yield rises.
A Simple Illustration
A general investor purchases a $100 bond, set to pay $110 in one year. If he would wait to redeem the bond until it matures, his yield would be 10%. Suppose that the investor needs cash two months in and decides to sell his bond before maturity. Since the maturity date is closer than it was when he originally bought it, he can charge more than the $100 he paid two months earlier. He succeeds in selling the bond for $102, walking away with a $2 profit. For the second buyer, collecting the bond at maturity for $110 provides an $8 profit, yielding 7.84% on his purchase price of $102. Thus, as the price of the bond rose (from $100 to $102), its yield fell (from 10% to 784%).
If, at the time that the first investor sells the bond, the price of the bond had dropped to $95, the first investor would be taking a $5 loss, whereas the second investor would be making a $15 profit when the bond is redeemed upon maturity. Because his purchase price was $95, his yield is 15.8% ($15 is 15.8% of $95). Thus, as the price fell (from $100 to $95), the yield rose (from 10% to 15.8%).
GOVERNMENT BONDS, T-BILLS
The U.S. government also sells bonds to raise money. These bonds are called Treasury bills or T-bills. All government bonds are backed by the “full faith and credit” of the U.S. government and are therefore considered the most secure bond in which one can invest. The market views U.S. bonds as having ‘no credit risk’; it is virtually certain that both the principal and the yield will be paid and on time. The most commonly traded Treasury is the ten-year Treasury bill.
The prices of Treasuries are in constant flux. Because of their security, people flock to Treasuries at any sign of instability in the market. As the market changes, so does the demand for, and therefore the price of, U.S. Treasuries.
Because Treasuries are the most secure investment, all other investments are assessed in relation to Treasuries. All investments are considered to be higher risk than Treasuries, and their yield must be higher accordingly (higher risk = higher reward). The credit rating of the investment company is compared with that of Treasuries, and the yield is determined proportionately.
SETTING THE RATE UNDERSTANDING THE COST OF FUNDS
When a bank is approached for a $1,000,000 loan, it calculates: “If we had $1,000,000, we could buy $1,000,000 worth of Treasuries which will yield, for example, 3.5%. For us to lend on this property, which is a greater risk than Treasuries, we need to see at least 1.5% more.” Therefore, the rate for this loan is set at 5% (3.5% + 1.5%). The difference between the cost of funds (measured by a particular index rate, such as the T-bill), and the rate quoted by the lender is called the spread.
The individual lender and the type of loan also influence the spread that a lender will demand. For example, safer investments, such as loans on multifamily properties (see 3.2), will typically have a smaller spread (lower risk = lower reward).
When a borrower requests financing from a lender, the lender will give a verbal statement, or a quote, which contains the main features of the loan: the amount, term, and interest rate. Although all lenders base their rates on a common index, such as the Ten year T-bill, some tie the rates to it more closely than others, depending on the source of the money that they are lending.
Commercial Banks and Wall Street Lenders
Some lenders, such as commercial banks and Wall Street Lenders, lend their borrowers money that they themselves borrow from the government. These lenders run a risk by quoting a flat rate for their loans. If they quote to a borrower a rate of, for example, 5%, which they intend to obtain from the government at a rate of 3.5%, they expect to make a 1.5% profit from the loan. However, if by the time the loan is closed, the government’s rate rises to 4%, and they must still keep to their quote of 5% for their borrowers, they have lost 50 basis points of their spread. [A basis point is one-hundredth of a percentage point (0.01%). 1% = 100 basis points. Basis points are often used to measure changes between yields since these often change by very small amounts.]
Because of this, these lenders do not quote a flat rate but rather a spread above a given index. For example, the lender may quote a loan as 1.5% above the T-bill. Then, when the deal is closed, the rate is locked at 1.5% above the rate of the T-bill for that day. Thus, if the bank’s funds’ cost rises or falls before locking the rate, the borrower’s rate is accordingly affected. This way, the potential risk to the lender is transferred to the borrower. Therefore, when going into the loan, the borrower must keep in mind that the cost of funds may have increased by the time the loan is closed, thus giving him a higher total rate.
Floor and Ceiling
Lenders need to be able to insure themselves a certain minimum level of return on their loans, even when quoting a spread. In a downward market, when rates are falling, a lender may propose a floor. A floor is the minimum amount a lender will accept in interest, no matter how low the index falls at closing.
Conversely, a borrower may request a ceiling from the bank in an upward market. This is the opposite of a floor and ensures that the overall interest rate of the proposed loan cannot rise above a certain point, regardless of where the index rate is holding at the time of closing. In these cases, a bank may actually have to make less than their preferred 1.5% spread.
The source of funds for savings banks is usually money that they receive from their depositors. The rate that they provide their depositors is usually less than the rate that the government charges. Nevertheless, the rates that they charge for loans are based on a spread above the cost of funds. In today’s market, a bank typically marks up its mortgages by 1.5% above the market’s cost of funds. Because the spread is based on the cost of funds and they are actually paying less than the cost of funds for the money that they lend, savings banks make a larger profit per dollar.
Unlike commercial banks, the profits of savings banks are not directly tied to the cost of funds at closing. They can quote a flat rate without risk. Their profit margin is calculated in relation to the rate of interest that they pay their depositors, which stays the same regardless of the cost.
Two other common indexes for setting rates are LIBOR and Prime. LIBOR stands for London Inter-Bank Offered Rate, and its interest rate is typically fixed for only 30 to 90 days. The prime rate corresponds to the rate of overnight funds. A benefit of Prime is that it doesn’t fluctuate on a day-to-day or month-to-month basis but is set by the chairman of the Federal Reserve. The rate stays stable until the Federal Reserve meets and resets the overnight rate, which affects Prime accordingly. Prime is most commonly used for home equity loans and credit card loans.
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- How do you buy US Treasury bonds?
- US Government bonds can be purchased directly from the US Treasury Department through their website, TreasuryDirect.gov. Individuals can create an account and buy Treasury securities in various forms, such as Treasury bills, notes, bonds, and TIPS. Alternatively, investors can also buy US Government bonds through a bank, broker, or financial institution that offers Treasury bonds as part of their investment products.
- What is LIBOR?
- LIBOR stands for London Inter-Bank Offered Rate. It is the benchmark interest rate that banks in London charge each other for short-term loans. LIBOR is published daily and is used as a reference rate for many financial transactions globally, including loans, derivatives, and bonds. It is calculated for different currencies and different maturities, ranging from overnight to 12 months. While LIBOR was previously based on actual interbank lending rates, it is now calculated based on submissions from a panel of banks, which has led to some controversy and calls for reform.
- How is Prime different from LIBOR?
- Prime and LIBOR are two different benchmark interest rates used in financial transactions. Prime rate is the interest rate that banks charge their most creditworthy customers for loans. It is usually based on the federal funds rate and can vary among different banks. LIBOR, on the other hand, is the interest rate that banks charge each other for short-term loans in London. It is used as a reference rate for many financial transactions globally, including loans, derivatives, and bonds. While both rates are influenced by market factors, they serve different purposes and are calculated differently. Prime rate is typically higher than LIBOR because it reflects a higher credit risk for banks lending to individual borrowers compared to interbank lending.