Pricing in profit

1. Pricing in profit

Welcome back! In this video, we'll review how trading impacts the lender's profit and the fees charged to borrowers.

2. The financial system

As seen earlier, the financial system is a big loop that transports money from those who have too much to those who have too little.

3. The financial system

We learned that when lenders sell their mortgage loans to investors, they can make money on the trade, called a premium.

4. The financial system

Lenders also make money by charging fees to borrowers. So lenders have two ways of making money: through fees and trade premiums. This sounds too good to be true for lenders; they can make so much money from this process, right? Well yes! And no.

5. Competitive markets

Lenders can make a lot of money. They don't have total control over how much they make. This is because lending is a highly competitive market. A competitive market has many buyers and sellers for identical or similar products. Per the Consumer Finance Protection Bureau, there were 4,338 mortgage lenders and 23 point 3 million loan applications in the United States for 2021. Because of all the participants in the market, no one buyer or seller could set a price. Why?

6. Competitive markets: lenders

In a highly competitive market, picking the right price is like a game of tug-of-war: if a lender charges more than their competitors, they may lose the sale to another lender charging less. And if the lender charges too little, they might not make enough money to pay their employees and they will go out of business. So lenders are constantly analyzing their profit margins to ensure they are in line with the market and not over or undercharging.

7. What is profit?

Profit is simply the money made after all expenses have been paid. Mathematically, it is revenue minus expenses. Revenue is the total money made from doing business. In lending, this would be any fees as well as trade premiums earned. Expenses are the business costs, for example, paying the mortgage banker, office expenses, or discounts given to the borrower. Let's put this all together with an example. If revenue is 50,000 and expenses are 30,000, what is profit? We would simply subtract expenses from revenue and have 20,000 left over.

8. What is loan margin?

Loan profit margin is specific to lending and refers to the percent of the profit earned for every dollar lent. Mathematically, it is just profit divided by the loan amount. For example, a loan with 14,000 in profit and a loan amount of 100,000 would have a loan profit margin of 14%.

9. Pricing and target profit

Every business has a target profit they aim to achieve. If you were to start a painting company, how would you know how much to charge for a job? Usually, you'd start with the cost of materials and labor and then apply your target margin. Lenders also operate this way. They aim to make a certain profit margin based on the fees they charge and the premium they make from trading.

10. Pricing and target profit

Having higher margins is not always a good thing. Because of the competitive nature of the lending, when profit margins are higher than their target, it may be an indication that the business is charging too much. In a competitive market, they could be losing customers due to their higher prices, so it may be best to lower prices to remain competitive within the market and capture more customers.

11. Pricing and target profit

And when profit is lower than the target, the lender needs to raise prices; otherwise, they risk going out of business. Lenders generate income from trading their mortgages on the capital markets, so they are sensitive to trading activities and the financial markets. This is why when you hear about central banks raising or lowering interest rates, pay attention: it impacts you! The lender must change their rates and fees when markets change to maintain their target profit.

12. Let's analyze!

Alright, let's put this knowledge to use and analyze our trading data.

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