When you take out a mortgage, you typically plan to repay it over 15 or 30 years. However, it’s important to know that many banks and lenders originate these loans with the intention of selling them to other investors. The secondary mortgage market significantly influences your ability to secure a mortgage and the cost of that loan, yet many homebuyers are unfamiliar with its workings. Here’s what you need to understand about the secondary market and its impact on your mortgage.

What is the secondary mortgage market?

The secondary mortgage market is where investors buy and sell mortgages that have been securitized—grouped together into bundles of multiple individual loans. Mortgage lenders create these loans and then sell them on this market. Investors who buy these bundled loans acquire the right to collect the payments owed.

Similar to other securities markets, the value of mortgages in the secondary market is influenced by their risk and potential return. Higher-risk loans need to offer higher returns, which is why individuals with lower credit scores often face higher interest rates.

Primary vs. secondary mortgage market

The primary mortgage market is where borrowers obtain mortgages directly from lenders. For instance, if you approach a local credit union or several banks for a mortgage quote, you’re engaging in the primary mortgage market.

In contrast, the secondary mortgage market does not involve borrowers. Instead, it’s where lenders sell the loans they’ve originated to investors.

How the secondary mortgage market works

After originating a loan, a lender often sells it on the secondary mortgage market, although they may retain the servicing rights. Many lenders sell these loans to government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac or to other aggregators. These aggregators may repackage the loans into mortgage-backed securities (MBS) or hold them on their own books to collect interest payments from borrowers.

To be sold to GSEs, loans must be conforming, meaning they must meet specific standards set by the Federal Housing Finance Agency (FHFA). These standards include:

  • A maximum loan amount of $766,550 for 2024 in most areas, though it can be higher in certain expensive locations (up to $1,149,825).
  • A down payment of at least 3 percent relative to the loan’s size.
  • A credit score of at least 620 to 650.
  • A debt-to-income (DTI) ratio ideally of 36 percent or less.

Conforming loans are in high demand, which helps lower mortgage rates for borrowers who meet these criteria. Conversely, jumbo loans, which exceed these limits, are not considered conforming loans.

1. A borrower takes out a loan

A homebuyer secures a mortgage (a conforming loan) from a lender, obtaining funds to purchase the home. The lender holds the mortgage note and a promise of repayment at a specified interest rate.

2. The lender sells the loan to an aggregator

The lender sells the mortgage to a mortgage aggregator, such as Fannie Mae or Freddie Mac, which purchase a significant portion of U.S. mortgages. By selling the loan, the lender receives cash, which it can then use to issue additional loans. The lender might retain the servicing rights to the mortgage and earn fees for managing it, but no longer receives payments of principal or interest, as the aggregator now owns the loan.

3. The aggregator bundles the loans into mortgage-backed securities

The aggregator acquires numerous conforming loans and combines them into mortgage-backed securities (MBS). For instance, 1,000 individual mortgages might be packaged into a single MBS. This diversification reduces risk compared to individual mortgages, similar to how a mutual fund spreads risk across multiple companies.

Aggregators can create various MBS investment products with different risk levels and returns, offering bonds with varying degrees of safety and payout structures. Some MBS might only provide interest payments, while others might include principal payments or a combination of both. If the aggregator also purchased the servicing rights, it might either service the loans itself or sell these rights to another party.

4. Investors buy the securities

The aggregator offers the MBS to investors, including pension funds, mutual funds, insurance companies, and other income-focused entities. The aggregator receives cash from these sales, which it uses to buy more mortgages and repackage them. Investors acquire the MBS, which generates income from mortgage payments and can be held or resold. When the MBS matures, the investor is paid off, and the cash can be reinvested in new MBS or other opportunities.

Secondary mortgage market example

Imagine you take out a mortgage to buy a new home. The lender provides the funds for your purchase, and you agree to repay the loan over a set period. Behind the scenes, the lender sells your mortgage on the secondary market for cash. This sale provides the lender with additional capital to issue more loans to other borrowers.

Once your mortgage is sold on the secondary market, several things could happen. The buyer might choose to hold your mortgage and collect the interest payments directly, or they could bundle your mortgage with others and sell it as a mortgage-backed security. Regardless of what the buyer does with your mortgage, it does not affect you as the borrower.

Why does the secondary mortgage market exist?

Creating new securities from mortgages is a complex process, but it provides significant benefits to all participants in the mortgage market, including borrowers, investors, banks, aggregators, and rating agencies.

The secondary market allows lenders to bundle and sell their mortgages, which in turn enables financial institutions to focus on their specialized roles. For example, a bank might originate a loan and then sell it on the secondary market while retaining the servicing rights.

As a loan originator, the bank is responsible for underwriting, processing, funding, and closing the loan. It earns fees for these services and may choose to hold or sell the loan.

As a loan servicer, the bank earns a fee for managing tasks such as processing monthly payments, tracking loan balances, generating tax forms, and overseeing escrow accounts.

Even if a lender decides to keep the loan it originated, the presence of an active and liquid secondary market provides an opportunity to sell the loan or servicing rights if desired. This flexibility benefits the lender by maintaining liquidity and capital for additional lending activities.

Pros and cons of the secondary mortgage market

The secondary mortgage market has its advantages and disadvantages:

Pros

  • Lower Costs for Borrowers: The secondary mortgage market can help reduce expenses for borrowers by improving efficiency in the lending process.
  • Investor Flexibility: Investors, including banks, pension funds, and hedge funds, can select specific types of securities that align with their investment goals and risk tolerance.
  • Increased Liquidity: Lenders can offload certain loans while retaining others they prefer to keep. This process allows lenders to use their capital more effectively, earning fees from underwriting and selling mortgages, and then reapplying that capital to issue new loans.
  • Aggregator Fees: Entities like Fannie Mae and Freddie Mac generate revenue by bundling and repackaging mortgages, creating mortgage-backed securities with desirable features.

Cons

  • Investment Risk: Mortgage-backed securities can be risky investments. If borrowers default on their loans, investors might incur losses, which could also impact the broader economy.
  • Impact on Returns: Returns for investors may be affected if borrowers refinance or repay their loans earlier than anticipated, potentially reducing expected earnings.
  • Strict Eligibility Criteria: Government-sponsored enterprises (GSEs) have stringent requirements for the loans they guarantee. This can lead to limited options for borrowers with poor credit scores, who may face higher interest rates or difficulty qualifying for loans.