Why Aren't Business Loans Priced Like Regular Mortgages?

The United States has a unique mortgage product that has helped tens of millions of Americans become homeowners. That is the 30-year fixed rate mortgage. From a banking perspective, that is a really impressive deal. A loan for 30 full years, and the interest rate never changes? Wow!

In reality, how does a bank or a credit union make a loan like that work? Consider that in banking, you fund loans with deposits. Do credit unions have deposits that will be left in place for 30 years? In all likelihood, probably not. That means if interest rates increased, the credit union would have to pay more for deposits to keep money at the institution, but it would be unable to increase the interest rate on the 30-year mortgage. It seems like making a loan with a fixed interest rate for 30 years could be risky business. What if over a 30-year period, the deposits became more expensive than the mortgage?!

The truth of the matter is, a 30-year loan is not really funded by deposits in the long run. What happens is the credit union makes the 30-year loan, and then it turns around, sells the loan to someone else, and the credit union then gets all its money back. Viola! The deposits are no longer tied up in a 30-year loan, and they now have more cash to make other loans with.

Who is buying these 30-year fixed rate loans? Investors, typically insurance companies and retirement funds. They need a predictable long-term stream of income, and what is more predictable than someone paying their mortgage every month? So what really determines the interest rate on a 30-year loan is what these investors want their return to be. This is usually a much lower interest rate than the rates a credit union would typically charge on a loan. But at the end of the day, it is not the credit union who will own the loan, so the credit union doesn’t have to worry about balancing this interest rate risk.

When a loan is underwritten to a standard which the investors are willing to buy it, we call it a “conforming” loan. A huge mistake credit unions might make is trying to price all their real estate loans like conforming loans, when they are not all conforming. A non-conforming loan is one that will not be purchased by investors, so why should they be priced low like investors are buying them?

Non-conforming loans should be priced based off the underlying deposits, not based on what secondary market investors want. The act of trying to match the price and term of deposits with the price and term of loans is called “asset-liability management” which is abbreviated as ALM. All non-conforming loans should be priced according to ALM principles, and not rates found in the secondary market.

We should consider that all business loans too, even those for commercial real estate, are non-conforming loans. There is a secondary market for commercial real estate loans, but those investors do their own underwriting and do not purchase loans from banks or credit unions. In light of these facts, that means a credit union should also price their commercial real estate loans according to ALM policies.

In other words, we should ask ourselves what is the cost of a five-year deposit, and then add a percentage on top of that to get our 5-year fixed loan rate. Even if someone is financing rental houses, they should be priced according to ALM and not what secondary market investors pay for home mortgages. This is, of course, because the business loan to finance rental houses can’t be sold, or won’t be purchased by those investors in the secondary market.