When you take a loan, the bank can “sell” your loan to an investor. What does that process look like, and why would an investor want to buy loans?
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Imagine a world where there’s a super popular toy that costs a quarter.
Let’s say that you get two quarters from your parents. Instead of just spending that money your friend comes up to you and says they don’t have a quarter to buy the super popular toy. They want the toy really badly. They’ll give you 2 cents a week for a year if you give them a quarter today. This is a pretty good deal for you because you’ll end up with a little over a dollar in a year for your quarter today. You can buy four of the toys your friend buys today in a year. But this is pretty risky because maybe your friend doesn’t pay you back. So you agree that if your friend doesn’t give you two cents every week you get to take the toy they bought and you know that your friend gets a nickel every week for their allowance so they’ll have the money to give you every week. You also know you can sell the toy to another kid for a quarter if your friend welches.
This is a pretty good deal for everyone. It’s such a good deal that another friend at school comes up to you and asks to borrow a quarter to buy the same toy. You give this friend the same deal and now you don’t have any quarters left. Then the next day a third friend asks to borrow a quarter and you’d like to do this deal because you’re now getting 4 cents a week and would like to get 6 cents a week but you’re out of quarters and won’t have another quarter to lend out until seven weeks later.
So you go to your older brother who mows lawns during the summer so your brother has a lot of quarters. You tell him about the terms you’ve got with your friends and your brother says he’ll buy the rights to the 2 cents per week for fifty cents. So instead of getting a little over a dollar in a year you get half of that now. He also says that he’ll take over collecting the 2 cents from your friends so long as you make sure the kid you loan the quarter to has a weekly allowance of at least a nickel.
You sell the two loans to your brother for a dollar. You go back to the third kid and loan him a quarter. Word gets out and half the kids at school borrow a quarter from you. You sell the loans to your brother for fifty cents. Your brother realizes this is a good deal for everyone but doesn’t want to spend all day at the elementary school collecting pennies so he tells your best friend who knows all these kids that if your best friend collects the 2 cents every week from all the kids then he’ll get 1 cent per month for every loan that he collects from. So your best friend collects all the money, keeps his 1 cent a month and gives your brother all the money.
You’re able to keep loaning quarters out by selling the loans to your brother. Your brother is able to see his lawn mowing money that was just sitting in his piggy bank grow because you’re out there hustling to lend quarters. Your brother gets his money every month because he’s paying your best friend to collect the weekly payments and take back toys when necessary.
If you wouldn’t have sold these loans to your brother then none of this happens. You would lend out your two quarters and you would have been done. The kids at your school wouldn’t have been able to buy the hot new toy. Your brother’s lawn money would have just gathered dust in his piggybank and your best friend wouldn’t be making any money.
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So the reason a “bank” sells a home loan right after making it is two-fold. First, it’s a matter of specialization. Businesses that are good at giving out loans, i.e. doing the work of looking at income, appraising the value of the house, interfacing with the customer, are efficient at doing that. In the example above, you are in a position to know the allowances of kids, how trustworthy they are, etc. because you go to school with them. But businesses in that position may not have a lot of capital to lend out because managing capital is a different skill set than marketing to home buyers and processing their loan applications. Second, even if a business was good at managing capital they probably don’t have capital. They might have a little capital to lend out to get the ball rolling like the kid in the example above but they need more capital to make more loans.
As to why an investor would want to buy a home loan? Generally, investors don’t like buying home loans. Home loans are relatively safe compared to other investments but they don’t pay much interest, have a long payoff period, and can be paid off in full with no penalty by the customer. Specifically, a fixed rate is pretty terrible for an investor because the investor is locked into getting 3% interest for thirty years even when the market is paying 8% interest. These are all good things for home buyers but bad things for investors.
So the majority of home loans are purchased by Freddie and Fannie Mae which are two corporations that are the brother in this situation. They have a lot of money and they use it to buy loans so that lenders can make more loans. They are publicly chartered corporations which basically means they were started by the government to buy these loans in order to increase the availability of home loans and increase home ownership in America. They aren’t government agencies but for-profit corporations created by the government for this specific purpose. They make money (hopefully) but aren’t going to ever get out of the loan-making business or expand into investment banking.
They don’t just buy any home loan though. They have standards that must be met for the loan to be bought. The home buyer must have a certain amount of income, the income must be documented in certain ways, the property must be of a certain type, they will only lend 80% of the value of the property, etc. If a loan is made by a lender (the kid/you in the example above) that doesn’t meet the criteria (the kid doesn’t get an allowance) then these loan buyers will refuse to purchase it. The kid wouldn’t be able to sell it to their brother and would have to just collect the money themselves. But so long as a lender makes a loan to a purchaser that meets those criteria then the loan will be purchased by these entities on what is known as the secondary mortgage market.
Loans that do not meet those criteria will not be bought and these are what are known as portfolio loans because lenders that make them must keep the loans in their own “portfolio” of investments.
The secondary mortgage market in America allows for the fixed 30-year mortgage to exsist. If the government hadn’t created these brother entities to purchase home loans you wouldn’t just see interest rates on home loans go up you’d see market movements where suddenly you just couldn’t get a fixed-rate mortgage in America.
Also, these entities generally aren’t interested in running around and collecting money from people so they pay loan servicers to collect the money. So one entity will make the loan to you, then immediately transfer the servicing of the loan to an entity that specializes in servicing the loan, and then will sell the loan on the secondary market. So you may get the loan from Loan Depot (RIP), you might send your first check to Chase all the while the monthly payments are going to a third party that bought the loan.
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