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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The bank sells off a large lot of things at once like mortgages to reduce the liability it has on its books. This usually happens as we approach the end of the banks fiscal year so they can make the books look better than they are.
The reason a bank loans you money, is because you guarantee to pay it back plus some interest over a long stretch of time. If the bank wants to quickly unload the liabilities, they may sell to someone who is willing to wait long term to collect the interest. So the bank sells a large group of loans to investors for the original capital plus a small % to at least recoup what they have put out.
The investor then gets a large grouping of loans that will pay them the money back plus the interest over time. So their benefit is the collection of the interest. The other potential benefit to the investor is that they are now in line to collect whatever asset you used as collateral – particularly houses.
In a long term market, real estate goes up. So a company that buys a bunch of risky debt on real estate could potentially make more than they would have collected by repossessing and selling or repurposing the asset.
If you actually add up all the interest you pay over the course of a 30 year loan, it can be just as much as the original price of the loan or more.
So if you have a good credit score, your loan is considered a fairly safe and reliable investment – you’re gonna pay your 5.275% compound interest monthly with just as much reliability as any business or government would, and if you don’t they can foreclose.
It’s not a super high-yielding investment, but it is a relatively safe one backed by the value of your home.
Banks sell it off because they’d rather just pocket the loan origination fees and flip that money into more loan origination fees or some other higher yield investments.
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An investor might want to own an asset with a certain amount of returns over a certain period. For example, a pension fund might need to have a 3% return on an investment of $50million dollars over the next 5 years in order to meet their obligations.
Pension funds, though, don’t have the ability to originate loans. Banks, knowing this, can make a bunch of these loans in smaller amounts and package them into a $50 loan resale to the pension fund. The bank earns fees along the way and also get to make more loans once they sell the $50m to the pension fund (since they’ve received the money and offloaded the risks)
The pension fund gets their investment requirements met as well.
Imagine that you own a rental home that you pay a mortgage on, but still profit $500/mo from the rent.
You have an opportunity to buy a rental property that could earn you $1500/mo. However, in order to do that, you will need to sell your first rental property to use the money/capital from that large one-time transaction to reinvest into something with a higher yield.
That’s basically what banks do with loans.
This happens all the time, although it’s really rare for a bank to sell an individual loan. They’re typically sold off in blocks as a “Mortgage Backed Security,” and investors buy those securities.
Why would a bank do this? (1) the bank makes money from origination fees and other costs of the loan which are paid by the borrower; (2) banks are limited in how much debt they can have on their books relative to their deposits — if they sell off the mortgages, then the amount of debt that they have falls, and they can make more loans. So, the bank’s approach is: (a) issue a mortgage, collect origination fees, (b) sell the mortgage back off, (c) go back to (a).
Why would an investor do this? Because it’s an investment, and it’s fairly low-risk. They get a string of future payments that, they believe, is going to be worth more than the money that they pay in. And, if they want to, they can then sell that investment in the future.
Note that the investor is different than the loan servicer. A loan servicer is responsible for collecting payments from borrowers, taking care of escrow, sending out statements and so on. They do this under a contract (indirectly) with the investors.
Finally, note that the price that people are willing to pay for your loan will change over time so that your loan may be worth more or less to an investor than your payoff value. Let’s say that you borrowed money in 2017 at 3% that required you to pay $1,000 a month for the next 30 years,. Then, 5 years later, your best friend borrowed money in 2022 at 6% that required him to pay $1,000 a month for the next 25 years. To an investor, your mortgage is worth just about as much as your friend’s, even though your principal amount is significantly higher. Why? Because it generates exactly the same cash flow to the investor: $1k/month for the next 25 years.
This last part is interesting: technically, if owed, say, $100,000 on a mortgage that paid $1000/month at 2%, you ought to be able to go to whoever owned that mortgage and say something like “Look, I know my mortgage isn’t worth $100,000 to you right now. How about if I buy it from you for $90,000? That’s a win for you AND a win for me.” But, for various reasons, that’s nearly impossible.
[The financial meltdown of 2007/2008 was caused, in part, by Mortgage Backed Securities. There have been a number of reforms, both governmental and at lenders/investors intended to prevent that from happening again.]
You take out a $100,000 loan that will accrue $10,000 in interest over the 10 years you pay it off. Essentially, you owe the bank $110,000 for the $100,000 they loaned you.
**The bank makes $10,000 in profit from the loan.**
The bank doesn’t want to wait 10 years to get their full return. 4 years into the 10 year loan and after collecting $4,000 in interest, they say to an investor ‘hey, we’ll sell you the remainder of this loan for $4,000.’ Which essentially means the investor is now entitled to receive the interest payments on the loan instead of the bank for the remainder of the term.
So instead of a $10,000 return over 10 years, the bank gets $4,000 from interest payments and another $4,000 from the investor. The investor then collects the remaining $6,000 in interest that has to be paid, a 50% return on the $4,000 they bought it for.
In the end, the bank profits $8,000 ($4,000 interest + $4,000 from investor), and the investor profits the other $2,000 (bought the loan for $4,000 and collected $6,000 in interest), totalling the $10,000 in interest the borrower had to pay.
‘Selling a loan’ is just a way to get a return faster (as the lender), but the return will always be less than if you just collected the rest of the interest payments.
An investor might want to collect interest on those loans, but doesn’t want to deal with the hassle of selling the loan to you, maintaining the mortgage, accepting payments from you, dealing with phone calls from you, tracking you down if you stop paying, etc. The bank handles the administrative nonsense for a share of the interest, the investor fronts the money and takes the rest of the interest.
There’s two ways this can happen.
First, the bank lumps a bunch of loans together and sells a bunch of loans to an investment firm.
Second, is someone fails to pay back their loan, so it’s sold to a collector.
It sounds like you’re asking about the first situation. So here’s what that looks like:
A bank has 200 open loans. They average a value of $10,000,000. And these loans are at 7% APR. This means if the bank wants to just sit on these loans they’ll eventually make back their $10 million plus probably another $5 million in interest. So if the bank *waits* they’ll make $5 million profit. But that will take a number of years. And maybe they want to go make more loans now. So what they’ll do is they’ll sell that debt. They’ll present the finances as I’ve just described them. $10 million loaned out. 7% interest. This stands to return $15 million. We will sell you this $15 million dollar opportunity for $12 million dollars.
So an investor will say “I don’t mind waiting, and I like having steady income.” So an investor will pay the bank $12 million and take ownership of those loans. Now the monthly loan payments go to the new owner of the loans. So they have a steady monthly stream of cash, which will ultimately pay out $3 million more than he paid in.
The bank makes $2 million pretty quickly just by getting people to take loans and then selling those loans. Now they have $12 million worth of loans to offer instead of just $10 million. So they can rinse and repeat but this time with even more money.
This is also basically how refinancing works, except the person paying the loan is more involved. Basically when refinancing you negotiate with a new lender for better terms and they give you the cash to pay off your other loan but now you effectively owe them that loan. Typically you’ll do this when interest rates go down so that you can pay it off faster or pay less each month. Sometimes they’ll reduce the principal for you, if you got kinda screwed the first time around but have otherwise been good. But that’s pretty rare.
So I hope that answers your question.
The other part is collections. If you just stop paying, they’ll sell your debt to a collector. The collector can do more to harass you than the bank can. But obviously they’re working with people that aren’t interested in paying the money back. So a collector will typically pay 1/2 value or somewhere like that to the bank for the full value of the debt. So if you haven’t made payments on a $1 million loan, the collector might pay the bank $500,000 for that debt. And the bank will take it because it’s better than the nothing you’ve paid them. The debt collector can then make your life really shitty until you pay back the money.
ELI5: You gave your brother four dollars, and he will give you back eight dollars, one dollar a week for two months. But now you need five dollars for something. So your sister gives you five dollars and will get your brother’s eight dollars. Your brother gets the four dollars he needs, you make a dollar and your sister makes three dollars.
non-ELI5: it basically has to do with who has more money, and who needs it quicker. Guy getting the loan clearly needs money the quickest. Bank has money but also offers lots of other services that it needs money to finance. Investors just invest and pay out money, so they have a lot more money for a very specific thing.
In a weird way it’s kinda like oil and vinegar, the money will just sorta ‘settle’ eventually where it’s supposed to.
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