Lesson 6 of 25 · 7 min

Why the lender's own borrowing sets the floor under yours

A rise in what the lender pays for money arrives in what you pay, through one of three channels it chooses.

Your rate is not a judgement about you. It is somebody else's cost of money plus a margin, and the first of those two terms is set in a market you are not in.

The complication is that the index your rate references and the lender's actual marginal cost of funds are different things. The index is a published reference. The cost of funds is what this particular institution pays to borrow this week, which depends on its own collateral, its own counterparties and its own standing. The gap between the two is a basis, and it moves.

Take an illustrative case. The lender funds at the index plus 0.34 points and lends at the index plus 1.95, so its gross margin is 1.61 points. Funding conditions tighten and its cost goes to the index plus 0.92. Your rate has not changed, the index has not changed, and the lender's margin has fallen to 1.03 points — a 36.0 percent squeeze, since 0.58 divided by 1.61 is 0.360.

A squeeze has to be resolved somewhere, and there are three places it can go. The spread can be repriced, which on a $565,000 balance means 58 basis points, or $3,277 a year and $273.08 a month. The advance rate can be cut instead, which costs the lender nothing to do and requires no notice. Or the facility can simply not be renewed. Which one happens depends on what the agreement permits, not on which one is smaller for the borrower.

The floor under your rate is somebody else's cost. When it rises, the question is not whether you pay for it but through which of the three channels.

Key terms

Cost of funds: What a lender actually pays to borrow the money it lends on. Distinct from the published index your rate is quoted against.
Basis: The gap between a published reference rate and a particular institution's real borrowing cost. It widens in a tightening.
Gross margin: The difference between what a lender charges and what its money costs. The quantity a lender defends when funding conditions move.

Worked example

A margin squeeze and its three exits

Illustrative figures. The lender funds at the index plus 0.34 and lends at the index plus 1.95. Its cost rises to the index plus 0.92. The borrower's balance is $565,000.

Gross margin before: 1.61 points
Gross margin after: 1.03 points
Size of the squeeze: 36.0%
Spread needed to restore the margin: 2.53 points
Cost to the borrower if taken in the rate: $3,277 a year
Cost if taken in the advance rate instead: Capacity, not interest

The same 58 basis points of pressure is either three thousand dollars a year of interest or an unannounced reduction in what may be borrowed. The lender chooses.

Check yourself

A lender funds at the index plus 0.41 and lends at the index plus 2.20. Its cost of funds rises to the index plus 1.18. What spread restores the original margin, and what does the change cost on an $840,000 balance?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.