Introduction to Mortgage Banking

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This article is part of Vaultedge Mortgage Industry Education series.

This article addresses the basic concepts of mortgage banking. While some of the concepts discussed here are valid universally, for the most part, the article deals with mortgage banking as seen in the US. We will look at what a mortgage is, who are the different players in mortgage industry and how they operate to complete the mortgage banking cycle. 

What is a Mortgage?

Mortgage (also called a Home Loan, outside the US) is a security interest in a real estate property; it is given by a homeowner to a mortgage lender in exchange for money to purchase a home. To further explain it, mortgage refers to the agreement between a financial institution and the debtor in which the institution lends money in exchange for a collateral which is the property being purchased, with the arrangement that once the payment of the debt is complete, the ownership of the collateral is titled to the debtor and the transaction is considered as complete. It can also be understood as an agreement between a borrower, known as the mortgagor, and a lender, known as the mortgagee, in which the borrower conveys an interest in a property to the lender as security for a loan. The loan is evidenced by a document called a note or mortgage note. In some states of the United States, a deed of trust is used in place of a mortgage as the security instrument.

What is the need for a Mortgage?

A home is the most expensive purchase for most people in their lifetimes and most people can not afford to pay the full price of a home upfront in cash (out of their savings or otherwise). A mortgage allows people to purchase a home by paying a small down payment and then agreeing to pay the rest over time keeping the home as security (collateral). 

Business Proposition

Profit is the motive for any business. In the mortgage industry, profits are obtained from 'interest' collected from the borrower on the amount owed by her. So one of the critical items both borrowers and lenders/investors are concerned with is interest rates. The interest rate dictates how much the borrower will have to pay for the use of the money and how much money the lender/investor will make for its risk and investment.

In the US most mortgages are given for a term of 30 years. The mortgage banker needs to able to fund a sizable amount and allow it to remain outstanding over the course of 30 years, which makes mortgage banking a very capital-intensive business. As the mortgage banker is lending out money to someone for a long amount of time, there is the risk of the borrower not repaying the loan or missing her payments. That is where the security behind the mortgage comes into play. The risk of losing the money lent is usually mitigated by the fact that the investor has a security interest in the property.

Also, this risk necessitates the existence of a secondary market which is a vehicle where investors can sell mortgages as a means of “offloading” the risk and recovering their investment by selling the loan in the secondary market.

Mortgage Lending

The job of a lender is to fund the purchase of a property and in return, the one borrowing is needed to sign a pledge towards the purchased property as security. This process is known as mortgage lending which is further associated with more interrelated and interdependent processes. All these processes are conducted depending upon the requirements of the investor and the government regulations. And finally, at the center of all these activities, there is the mortgage banker who mediates through the process to make it smoother by being the financial intermediary.

The participatory financial institution/organization provides a host of administrative functions after the loan has closed. Such services include collecting payments, managing escrow accounts, providing reports to investors on loan performance, and answering borrower questions.

Capital

To fund millions worth of mortgages, the mortgage banker has to accumulate the monetary requirement. Traditional banks and credit unions collect money from individuals or companies in the form of deposits and use this money to lend to borrowers. Other institutions (non-banks) can not collect deposits from individuals. Such companies sell their loans to an investor to realize profits and free up capital to further lend to the next borrower. To free up capital, lenders sell the loan to an investor for a premium after the loan is closed. By selling the loan, the bank has its capital back and is able to make another loan for another borrower. It is a win/win as the investor (who has the capital) gets the interest income that will be repaid monthly over the life of the loan and the lender recoups its capital to continue lending to other borrowers.

Depository Institutions: Some large mortgage banks that are also depository institutions- A financial institution (such as a savings bank, commercial bank, savings and loan association, or credit union) that is legally allowed to accept monetary deposits from consumers. Federal depository institutions are regulated by the Federal Deposit Insurance Corporation (FDIC).

Non-banks: An example of a non-depository institution might be an independent mortgage bank. While licensed to lend, the mortgage bank cannot accept deposits. Managing the flow of money is crucial to a mortgage banker.

Interest Rates

Interest rates play a very crucial role in the mortgage industry as the rate of interest is what determines if a lender would get a return on its investment and if a borrower can afford a loan of a particular amount. The interest rate, or rate of return, paid on that investment, is generally higher than that of other investments. For a borrower, the concern is affordability—how much will they pay in both the short term and over the life of the loan. For the investor, the concern is profit—whether they can they earn enough yield to justify lending out their capital for a lengthy period of time.

When interest rates decline, people take up more mortgages as their buying power increases and conversely when interest rates rise, people take fewer mortgages but still, it doesn’t halt the mortgage applications just bases them on affordability.

Key Processes in Mortgage Banking

Even though complicated, the mortgage industry has a very similar methodology of working to the other industries as in, they, just like other industries, market a product that attracts customers and then market that product to the customers it will attract.

The major functional areas in mortgage banking are:

1. Loan Production

The process of taking a mortgage starts at the loan production stage and spans until the end. This is the stage when the loan goes through a process of loan compliance and it is ensured that it matches the loan guidelines and governmental regulations. It involves processes like origination, processing, underwriting, and closing.

2. Funding, warehousing, and shipping

Funding is the simple act of funding the mortgage loan to the borrower. Most non-bank mortgage bankers utilize a warehouse line to fund loans, hence the term “warehousing.” Shipping refers to the process of delivering a mortgage loan to an end investor for purchase. The time period of warehousing ends when the loan has gone through and the end investor has purchased the loan and paid off the advance to the warehouse.

3. Secondary Marketing

Even though it is usually mentioned in the later processes of mortgaging, the secondary markets are very important parts of the process. They help to ensure that the loans are sold at a price which fetches a good return on the investment. It works behind the scenes to determine the interest rates for organizations as well as the price at which the properties will be sold.

4. Loan Administration

Also known as loan servicing, it services the loan as in, it is the part which includes activities like collecting payments, managing accounts, giving loan reports, answering borrower questions, etc. This is a charged service as the investors pay a service fee which also becomes a source of primary income for the mortgage banker.

Different players in the mortgage industry

There are different players supporting different processes in the mortgage industry. While every mortgage involves a Lender and a Borrower, depending on how the loan is funded and later on serviced and sold other players also are involved during the loan life cycle.

Mortgage Banker or Lender: An individual, firm, or corporation that originates, sells, and/or services mortgage loans. Mortgage bankers can be independent mortgage bankers or depository institutions.

Correspondent: A specialized type of mortgage banker whose function is limited to the production of mortgage loans that are then sold to other mortgage bankers under a specific commitment.

Broker: A firm or individual who, for a commission, matches borrowers and lenders.

Wholesaler: A lender who specializes in the purchase and servicing of mortgages obtained from other mortgage origination entities, such as brokers, correspondents, thrifts, credit unions, or commercial banks.

Warehouse Lender: A specialized type of mortgage banker who does not originate its own mortgage loans but funds the loans originated by a retail mortgage lender.

Borrower: An individual who is borrowing money from a lender to purchase a property, keeping that property in mortgage.

Conduit: An entity that issues mortgage-backed securities backed by mortgages that were originated by other lenders.

Investor: An entity that purchases mortgage loans that are originated by mortgage lenders and carries the loans in its books and earns interest on the loans.

Servicer: An entity that services the loan (i.e. collects payments, maintains escrow accounts for tax & other payments, provides customer support to borrowers) during the life of the loan.

Regulation

There are several laws that regulate the mortgage industry. The primary purpose of these regulations is to ensure that lenders make quality loans to worthy and well-informed borrowers. There are laws at Federal, State and local/municipal levels that regulate the mortgage industry. These laws are covered in detail in a later article. watch out this space.

Conclusion

Mortgage Banking is more than a business, it is the only way for the majority of people to fulfill their dream of owning a home. There are multiple players and multiple processes in the mortgage industry and these work in tandem to ensure that lenders make quality loans to worthy and well-informed borrowers while ensuring the interests of lenders and investors.