Have you ever heard the saying that someone “Makes Bank”? Banks are often seen as bastions of safety and money-making. It’s hard to imagine a bank that actually loses money (it happens…trust me). Bank do have several ways to drive revenue in the door, but this article will focus on one aspect of bank revenue – lending.
There are typically four ways in which lenders drive revenue through the door – 1) Front Points, 2) Back Points, 3) Interest Income and 4) Fee Income. It is important to understand each of these realms whether you are getting into the private loan business or you, yourself, are an active borrower.
Front Points: Front Points, known to most of the borrowing world simply as “points” are simple and straight forward. Points are fees that are charged to a borrower, usually as a percentage of the loan, that are fully earned when the note is originated. One “point” is 1% of the amount financed, so if a lender charges 2 points on a $100,000 loan, they are charging $2000 for the privilege of borrowing money from them. Usually in this situation, the borrower would sign a note that states they will owe the lender $100,000, but the lender would only fund $98,000 to them. The other $2000 goes immediately to revenue for the lender as “points”.
Back Points: Back points are a bit more complex to explain. Back points are sometimes referred to in the mortgage world as a “yield spread premium”. Normally, lenders will sell their loans off to a Wall Street Investment Pool or Traunch shortly after the loan is made. Prior to signing the loan papers, however, loan originators will check with that investment pool to get their “par rates” or “rate sheets” for that day. The “par rate” is the base rate in which a final investor will accept when buying the loan. If the lender charges more than the “par rate”, then the investor will pay them more when they buy the loan. If the loan originator charges less than par rate, then the lender will have to pay the investor more when selling the loan to them. A final investor’s “rate sheet” will tell a loan originator how much they will pay for the loan at different rates. For instance, if the lender has a part rate of 4%, the originator might say if you charge 4.125%, you will get an additional 0.5% on the loan. If you charge 4.25%, you will make an additional 1% on the loan. They might also say that you will get -0.75% for a loan at 3.875% and -1.25% for 3.5%. In this case, if the lender charges 4.25% on a $100,000 loan, they would be paid $101,000 for the loan at final sale. If, however, they were to charge only 3.5% for the $100,000, they would only be paid $98,750 for the loan. The difference between the loan amount and what the loan originator is actually paid is known as “back points”, or the “yield spread premium”.
Interest Income: Lenders that “portfolio” or hold on to their loans earn interest income when each loan payment is made. Not all of that interest that they receive is always profit, however, as most lenders are borrowing money to lend back out. The amount that it costs for a lender to borrow money is known as its “cost of funds”. Most of the time, the lender does not disclose its cost of funds, but it is important for a lender to make a “spread” over what it costs for them to borrow in order to make a profit.
Fee Income: I also call fee income “junk fees” because they are usually an arbitrary amount that the lender decides to charge for the pleasure of the borrower to work with the lender. If you see “underwriting fee”, “processing fee”, or “loan fee” on a truth in lending statement, those amounts go straight to revenue for the lender. Fees such as appraisal fees and title insurance are fees that are paid to third parties and wouldn’t be included in the lender’s fee income revenue.
Lenders find all kinds of tricky ways to make money through their loan activities, but understanding these four basic types of fees will help you to increase revenue if you are a private lender or save money if you are a borrower.