Becoming The Interest Rate Expert

Understand the five main variable components of rate-sheet pricing and interest rates

Insider

Victoria DeLuce

Building a rate sheet is a pretty simple mathematical equation. How much does the company get paid for that particular loan and how much does the company have to pay out.

Five main variable components go into rate-sheet pricing and interest rates. The bond price, servicing value, lenders’ cost to manufacture, loan originator compensation, and the borrowers’ risk profile.

For this segment we will focus on the bond price. We don’t have much control over the bond price and that’s why we hedge. Hedging protects against interest rate risk, i.e. the change in bond price from the time a loan is locked to the time a loan is closed and sold on the secondary market. If a loan is locked at a 7.000% interest rate today that pays the lender 300 basis points or 3 percent, and the bond price goes down by 200 basis points by time the loan closes, the lender will only be paid 100 basis points when they sell the loan. Hedging offsets the difference of that market movement.

The agreement the lender has with the broker dealer says in the event the market worsens, the broker dealer will make the lender whole, paying them the 200 basis points change in the market. Conversely, if the market improves by 200 basis points, the lender will pay the broker dealer the difference. In this scenario, the lender would be paid 500 basis points when they sell the loan, netting the original 300 they were hoping to make. Hedging is like insurance.

Hedging is important because bond prices move every day and intraday. Which is why we see re-prices to the rate sheet from time to time. Trader speculation, economic releases, the current state of the economy, and most of all supply and demand play into fluctuating bond prices. This past year the biggest driver for interest rate or bond price movement has been inflation and how the Federal Reserve has struggled to rein it in.

A great way to stay in the know is to follow economic releases such as the nonfarm payroll number and unemployment, which are typically released on the first Friday for each month.

Employment & Stability

The Federal Reserve, or the Fed, has two congressional mandates that date back to the 1970s: maximum employment and price stability. If we have runaway inflation, the Fed is not living up to the latter mandate. For most of 2022, inflation was running three to four times higher than what it should be. In order to regain price stability, the Fed started to increase the Fed Funds Rate. This is the rate at which banks borrow from each other overnight.

The thought process is if it costs more for banks to borrow from each other, that cost will find its way into consumer loans. If borrowers must pay more in interest, they will have less disposable income to put into the economy, hence slowing the economy and slowing inflation. On the flip side, in the event of recession bond prices would go up and interest rates would come down.

A great way to stay in the know is to follow economic releases such as the nonfarm payroll number and unemployment, which are typically released on the first Friday for each month. Consumer price index (CPI) is another hot release as of late. And, of course, follow the Fed announcements.