The purpose of this article is to explain the various types of lending institutions that can finance your home. Ultimately, your home loan is a commodity, so you should search for the least expensive form of financing, but this article will help you to decide which type of institution is best for you.
Banks and Credit Unions
Banks, and credit unions which function similarly to banks but have a membership requirement. Therefore, we will consider bank and credit unions synonymous for the remainder of this article and will refer to them as “banks”. Banks can either be federally or state chartered. The distinction between the two is where they are legally able to lend money. For state chartered banks, they can only lend in states where they have retail branches, whereas federally chartered banks can lend across state lines.
Simply put, banks take deposits from consumers and then use those deposits to lend money to consumers, effectively matching the demand for capital with supply. The bank’s profit is the difference between what they earn on money they lend less what they pay to depositors for the privilege of using their money.
However, most banks that make residential loans only retain a small portion of the loans they issue to consumers. Instead, banks will use their customers’ deposits to fund the loan, but shortly after closing, sell the loan in the secondary market for a fee. Once the loan is purchased by another institution they return the cash to their balance sheet to be used to fund new loans.
One important thing to note about banks that sell loans in the secondary market is that many will retain the responsibility of servicing of their loans (i.e. sending statements, collecting monthly payments and managing any escrow accounts for taxes and insurance). Banks often retain servicing so they can continue to engage with the customer and they are paid a fee by the buyer of the loan to perform this service. So if an institution retains the servicing on a loan, the borrower will make their payment to the bank and the bank will then forward those payments to the appropriate buyer of their loan.
Mortgage companies are regulated by each state they do business in and perform a similar primary lending function to banks. However, because mortgage companies cannot legally take deposits, they rely on borrowed capital to provide their loans. Often a mortgage company will maintain a line of credit (called a warehouse line) with a bank and they use these borrowed funds to lend to consumers. Then, once a mortgage company sells their loans, they use the proceeds from this sale to pay down their warehouse line borrowings to free up capital to make new loans.
A mortgage company makes money through both the premiums they receive when selling their loans and also from the difference between the interest rate on the loans they make and the rate charged on their warehouse borrowings. Most mortgage companies do not service their loans so there is a good chance that when a loan is sold, a third party will take over the obligation to collect borrower monthly payments. Also, because mortgage companies do not have the ability to hold loans for long periods of time, they often have more difficulty in making loans that don’t meet secondary market guidelines. Some mortgage companies maintain relationships with other institutions that can make these “portfolio” type loans, however it is a function that is generally easier for a bank to perform.
Prior to the financial crisis, mortgage brokers accounted for almost a third of all mortgages originated in the US. A mortgage broker’s role is to work with a customer, gather enough information to determine their eligibility and to provide a number of potential financing options across multiple lenders.
However, some unsavory mortgage brokers lost sight of this role and helped contribute to the financial crisis by placing borrowers in unsuitable loans while collecting fees from both consumers and lenders, a practice which has since been outlawed.
Mortgage brokers represent less than 10% of today’s mortgage market and these institutions do not actually lend money. Like mortgage companies, brokers are regulated at the state level, but they act more as a matchmaker, pairing a borrower with a lender, whether that is a bank/credit union or mortgage company. Today’s brokers are paid a fee by the lender that ultimately closes the loan. After the industry’s compensation change that prevented mortgage brokers from getting paid by both lenders and consumers on the same transaction, most brokers exited the business.
In summary, here are some key concepts to keep in mind when deciding where to get your mortgage:
- Often offer widest selection of loan products given their ability to sell loans or keep in portfolio
- Often retain the responsibility of servicing the loan
- May try to cross sell other financial products (deposit accounts, credit cards etc.)
- Cannot take customer deposits, so must sell their loans
- Typically do not retain responsibility for servicing the loan
- Can be structured to act in consumers’ best interest
- Few mortgage brokers are left
- Paid a fee from the lender that closes your loan