How Secondary Mortgages Make Money

Mortgage Markets

Maintaining a steady flow of revenue throughout the real estate market allows primary and secondary lenders to generate business and ongoing revenue. Mortgage banks act as primary, or temporary, lenders that originate mortgage loans and sell them to secondary lenders. Other institutions, such as commercial banks, act as secondary lenders that purchase bundles or packages of mortgage loan notes. And while primary mortgage lenders can make money from interest earnings generated by mortgage loans, the secondary mortgage market can generate more revenue streams by packaging groups of mortgage loans together.

The secondary mortgage market consists of lenders and investors who work in the public and private sectors. Government-based organizations, such as the Federal Home Loan Mortgage Co. also known as Freddie Mac, and the Federal National Mortgage Association, also known as Fannie Mae, play a pivotal role in purchasing mass numbers of primary mortgages and reselling them as packaged investment products. Other secondary investor types include insurance companies, pension funds and securities dealers. In turn, the secondary mortgage market enables primary lenders to free up the money tied up in mortgage loan notes and use it to finance future mortgage loans.

Secondary lenders use mortgage-backed securities to purchase bundles of mortgage loans from primary markets. Mortgage-backed securities are liquid, or cash-producing investments that primary lenders can hold, trade or sell on the stock market. In turn, secondary market lenders can lay claim to principal and interest payments generated by the loans that make up mortgage-backed securities. Secondary lenders also make money by selling mortgage-backed securities to private investors. Secondary markets can structure mortgage-backed securities in different ways, which affects the degree of risk an investor takes on and the number of shares an investor can purchase at a time.

The large numbers of mortgages purchased by secondary mortgage lenders can place them at considerable risk in terms of loan defaults, early loan payoffs and loan refinancing. As a result, the private mortgage insurance market was created to reduce the overall losses incurred within the secondary mortgage market. Private mortgage insurance, or PMI, provides some degree of protection in terms of reducing losses when homeowners and property investors default on loan obligations. During the loan origination process, homebuyers who put down less than 20 percent for a down payment are required to pay for PMI for certain types of loans, such as FHA loans. In effect, PMI pays secondary lenders a portion of the remaining loan balance in cases where a homeowner defaults on a loan. (See Reference 3)