Most mortgage banks are retail banks and offer a range of financial services.
Some of these services bring money into the bank. For example, deposit and savings accounts both increase the funds held by the bank. In return the customer gets some level of service and / or some amount of monetary return usually expressed as an interest rate.
With other services the bank loans money out. For example, credit cards, personal loans and mortgages all provide the customer with funds and reduce the funds held by the bank. In return the customer pays the bank an interest rate on the debt.
With large loans the bank typically holds some level of collateral which can be seized on default of the loan. For a mortgage this collateral is the house which can be repossessed on failure to meet the interest payments.
A bank makes money on its mortgage book if the revenue obtained exceeds its costs.
As a broad simplification mortgage book revenue can be considered as:
- Interest rate on mortgage loan.
- Any fees charged to set up the mortgage.
- Sale proceeds from any house repossessions.
Whilst costs can be simplified down to:
- Interest rate on the deposit funds which brought the money into the bank.
- Administrative costs of setting up and running the mortgage (and other costs).
- Loss of funds from default of loan.
The overall profits thus boil down to the sum of:
- Interest rate margin (+ve): Mortgage interest rate - deposit interest rate
- Administration margin: Mortgage fees charged - costs of running the book.
- Default margin (-ve): The loss from defaults less any recoveries.
Typically the expertise lies in determining the expected level of defaults for each tranche of customers and setting the mortgage interest rate at a level high enough to cover this loss, whilst at the same time low enough to remain competitive and sell enough business to ensure economies of scale.