The secondary mortgage market serves as a financial arena where investors engage in the buying and selling of aggregated collections of numerous individual loans, referred to as mortgage-backed securities.
Although you, as the homebuyer, may not be personally engaged in the process, the secondary market influences your capacity to secure a mortgage and the expenses associated with that loan.
Through the secondary mortgage market, borrowers might experience reduced expenses.
When you take out a mortgage, you typically anticipate that you will pay back your lender over a period of 15 or 30 years. However, a significant number of banks and financial institutions create mortgages only to sell them to different investors. The secondary market greatly influences both your ability to secure a mortgage and the associated costs of that loan, but many prospective homeowners remain unaware of its existence and operation. Here’s what you should understand.
What is the secondary mortgage market?
The secondary mortgage market functions as a venue where investors engage in the buying and selling of securitized mortgages, which are essentially grouped collections of various loans. Mortgage lenders create these loans and subsequently offer them on the secondary market. Investors acquiring these loans obtain the entitlement to collect repayments from borrowers.
Similar to any securities market, the worth of mortgages in the secondary market is influenced by their associated risks and anticipated returns. Loans that carry more risk need to provide greater returns, which explains why individuals with poorer credit ratings often face elevated interest rates.
How the secondary mortgage market works?
Once a loan is created, it is common for lenders to sell it in the secondary mortgage market, although they might keep the servicing rights. A significant number of lenders choose to sell their loans to government-sponsored enterprises like Fannie Mae and Freddie Mac, or to other aggregators. These aggregators have the option to repackage these loans into mortgage-backed securities (MBS) or maintain them in their portfolio to earn interest from the borrowers.
To be eligible for sale to GSEs, loans need to be conforming. This means they must adhere to specific criteria established by the Federal Housing Finance Agency (FHFA), the body responsible for supervising Fannie Mae and Freddie Mac. These criteria encompass:
1. A borrower takes out a loan
A buyer seeks financing from a financial institution through a mortgage (also known as a conforming loan). This arrangement provides the buyer with funds to acquire the property, with the lender retaining the mortgage agreement and the assurance of future repayment at a predetermined interest rate.
2. The lender sells the loan to an aggregator
The mortgage provider transfers the loan to a mortgage aggregator, typically Fannie Mae or Freddie Mac, which purchases approximately 66% of U.S. mortgages. By selling the mortgage note, the lender receives immediate cash, enabling it to extend another loan. The lender might keep the servicing rights for the mortgage, allowing it to earn a fee for that service.
The borrower is no longer responsible for making any mortgage payments, whether on the principal or interest, since the aggregator has acquired the loan by paying cash for it.
3. The aggregator bundles the loans into mortgage-backed securities
The aggregator continuously acquires conforming loans, gathering a large number of mortgages from across the United States. Subsequently, it organizes these loans into mortgage-backed securities (MBS). For instance, it could take 1,000 different mortgages and consolidate them into a single MBS offering. As a result of containing multiple mortgages, this MBS is considered to be less hazardous than investing in an individual mortgage; this can be compared to a mutual fund that holds shares in various companies.
4. Investors buy the securities
The aggregator offers the mortgage-backed securities (MBS) to a range of investors, including pension funds, mutual funds, insurance firms, and other income-focused entities. Upon selling the MBS, the aggregator obtains cash that can be utilized to purchase additional mortgage notes for future repackaging. Consequently, the investor acquires the MBS, allowing them to collect income from the mortgage payments or potentially resell it to another investor later on.
Ultimately, the mortgage-backed security reaches its maturity, and the investor receives their payment. With that capital, the investor has the option to acquire another MBS or allocate funds to different investments.