Lesson 23 of 25 · 7 min

What a lender's own funding cost does to your spread

In a tightening both legs can rise, and the discretionary one is the small number nobody attributes correctly.

Track 8 lesson 16 described the index leg as a pass-through that leaves the lender's margin untouched. That description holds while the lender's own funding cost tracks the index. Lesson 6 showed what the gap looks like when it does not. This lesson follows the gap through to a revision.

A prolonged tightening changes the composition of a lender's funding rather than just its price. Balances that paid little migrate to alternatives that now pay a great deal, and what replaces them is priced at or above the index. The blended cost rises faster than the index does. Margin compresses, not by decision but by mix. At the next review the pricing grid is rewritten, and spreads on facilities like yours widen.

Across one illustrative cycle the index moves from 3.90 percent to 6.75, a rise of 2.85 points. The spread moves from 1.80 to 2.25, a rise of 0.45. The rate moves from 5.70 to 9.00, a rise of 3.30. On a $1,668,000 balance, annual interest goes from $95,076 to $150,120 — $55,044 more, of which $7,506 came from the spread alone.

The attribution is where this bites. The spread accounted for 0.45 ÷ 3.30, or 13.6 percent of the increase. A borrower checking the index history finds 2.85 points of explanation for a 3.30-point move, and if they are not looking for a residual will conclude the whole thing was the market. The residual is small in points and not small in dollars.

There is one further asymmetry. The index component reverses when the cycle does. The spread component does not, because a grid rewritten upward stays where it was written until somebody reviews it again. Lesson 24 follows an index that nearly round-trips across two years; nothing in a spread is obliged to follow it back.

Key terms

Funding mix: The composition of a lender's sources of money, as distinct from their price. A tightening changes the mix, which moves the blended cost independently.
Spread review: The periodic rewriting of a pricing grid. Where compressed margin is recovered, and it applies to existing facilities rather than only new ones.
Ratchet: A component that moves in one direction and does not automatically return. A widened spread outlives the conditions that widened it.

Worked example

One cycle, both legs rising

A $1,668,000 balance across one illustrative tightening cycle.

Index, start and end: 3.90% to 6.75%
Spread, start and end: 1.80% to 2.25%
Rate, start and end: 5.70% to 9.00%
Annual interest, start and end: $95,076 and $150,120
Of which the spread produced: $7,506
Spread's share of the increase: 13.6%

Nearly $7,506 a year came from a decision rather than from a market, and it is the only part of the increase that will still be there when the index has come back down.

Check yourself

Across a cycle a facility's rate rose 2.60 points while the published index rose 2.18. The balance is $985,000. What was the spread's share of the increase, and what does it cost a year?

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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.