Today is another AMA episode, Ask Me Anything.  Ryan from Fresno, California asks. 

“I really enjoy your Real Estate Espresso podcast. Thanks for the great work.

The silly question has in my mind for a while. Why do banks, including lenders backed by Fannie Mae, make 30 year fixed loan to home buyers?  When I bought first home in China, all home loans are adjustable rate.  Let’s say the interest rate goes back to normal level  like 6-8%  2 years later, the bank (or whoever bought the security from bank) can still only get 4% for the remaining 28 years, do they lose money? On other hand, if interest rates go even lower, the home owner can always refinance. The bank does not have such freedom, will it put them at a disadvantage?

Regarding refinance,  what is good criteria to  apply for refinance? Interest rate dropped 10%? 20%? “

Ryan, that is a great question. In fact two great questions.

Let’s talk for a moment about how the banking system works. And let’s talk about how the banks make money. In the US, Canada, Europe, and much of the world banking system is based on a fractional reserve system.

That means that when depositors put say, $1 million in deposit at the bank, the bank makes money in several different ways. The bank is taking 1 million in deposits, but has the authority to write $10 million worth of loans against that 1M in deposits. The bank makes money on the difference between the interest rate it pays to depositors and the interest it collects from borrowers. Let’s do some simple math. Let’s say that the bank pays 1% interest to its depositor on the $1m deposit. Let’s say that it’s lending the money at 4%. The difference between the deposit and the loan is 3%. So the bank is making 3% on the money it loaned out for the first loan that it makes. But the bank gets to loan the money out another 9 times. In that case it’s making a full 4% interest times 9, which is 36%, plus the 3% from the original loan. So the bank is making 39% interest on the original deposit. That’s a pretty good rate of return. Now let’s say that interest rates go up during the term of the loan. Let’s say that the bank now needs to pay 4% to the depositors instead of 1%. In that situation the banks rate of return drops from 39% to 36%. They’re still very far from losing money. 

Understand, when the bank makes a loan that is insured by a federally backed insurer, whether it is Fannie Mae, Freddie Mac, or the US government directly through the department of housing and urban development (HUD ), that is about the lowest risk loan you can write. 

The business of banking is made lucrative by the bank leverage, that 10:1 leverage we just talked about. The other side of that is what happens when a loan goes bad. 

If the loan is a conventional loan, then the bank has to write down the loss from the loan and it needs to find another $1m in cash quickly, otherwise it can’t pay the depositors their money when they go to the bank to make a withdrawal. 

The other way that the bank makes money is through fees. They typically charge an origination fee at the start of a new loan. That fee is usually 1% of the loan amount. In the first year of the loan, the bank makes another 1% on each loan, which brings their total rate of return to 49% instead of the measly 39% they will make in subsequent years.

The second part of your question was about refinancing. Your question was about interest rates. It is true that getting a lower interest rate is part of the motivation for a refinance. But usually the main reason to refinance is to change how your equity is being used. Let’s say you own a building that has 50% equity. You might refinance to increase the loan amount and free up a bunch of equity. You can then take that money and go buy another building.