What Is the Secondary Mortgage Market?

What Is the Secondary Mortgage Market?

In the secondary mortgage market, investors and lenders buy and sell home loans and the rights to service those loans.

After a homebuyer takes out a home loan in the primary mortgage market, the lender might sell it in the secondary mortgage market. Doing so decreases the financial risks of a lender holding on to a mortgage and gives lenders cash to provide more mortgages.

Then, mortgage buyers such as Fannie Mae and Freddie Mac—two government-sponsored enterprises that are major players in the secondary market—group them into a package of mortgage-backed securities (MBS). The buyers make money from accumulated loan interest. In some cases, government agencies buy mortgages, such as FHA and VA loans.

In the final step, investors buy MBS shares. These investors generally include pension funds, hedge funds and investment banks. The secondary mortgage market appeals to these investors because the securities can deliver fatter returns than regular bonds while reducing exposure to higher-risk investments, such as stocks.

Key participants in the secondary mortgage market include:

• Mortgage lenders: Lenders originate home loans in the primary mortgage market and often sell them in the secondary mortgage market.
• Mortgage aggregators: Mortgage aggregators, such as Fannie Mae and Freddie Mac, don't lend money. Rather, they purchase home loans in the secondary market, then package them as securities for sale to investors.
• Investors: Individual and institutional investors purchase MBS because they're viewed as safe, attractive investments.

Primary vs. Secondary Mortgage Market

In the primary mortgage market, lenders originate home loans for consumers. In the secondary mortgage market, investors buy home loans packaged as mortgage-backed securities.

How Does the Secondary Mortgage Market Work?

Here are the typical steps involved in the second mortgage market:

1. Mortgage Bundling and Selling

Once an aggregator like Fannie Mae or Freddie Mac buys mortgages from lenders, it bundles them and prepares to sell them to investors.

2. Securitization

After buying mortgages, an aggregator typically securitizes the loans, creating a pool of mortgage-backed securities. These securities entitle an investor to share the principal and interest paid on loans included in the pool.

3. Loan Servicing

While the process outlined above plays out, a borrower whose loan is part of this pool continues making monthly loan payments as normal. The loan servicer may change after a mortgage is sold or may stay the same.

4. Payments to Investors

MBS investors typically receive monthly payouts from principal and interest paid by homeowners.

What Is the Purpose of the Secondary Mortgage Market?

The main purpose of the secondary mortgage market is to free up money, or increase liquidity, so lenders can originate more home loans. In addition, lenders eliminate the risk associated with the loans once they've sold them.

The secondary market also enables investors to share risks while helping to stabilize the housing market. What leads to this market stabilization? If a lender wants to sell a loan on the secondary market, it must follow standards for lending limits, minimum credit scores and debt-to-income ratios.

Pros and Cons of the Secondary Mortgage Market

As with any investment market, the secondary mortgage market comes with pros and cons.

How the Secondary Mortgage Market Impacts Borrowers

The secondary mortgage market impacts borrowers in several ways, such as:

• Providing better borrowing opportunities: When a lender offloads some of its mortgages, borrowers benefit by gaining easier access to money.
• Keeping interest rates lower: Because lenders decrease their risk by selling mortgages, they can offer more attractive mortgage rates.
• Enabling longer loan terms: Because the secondary market frees up cash for lenders, they're able to provide longer loan payoff periods (such as 15 or 30 years) rather than shorter periods.
• Allowing early payoff: It makes it easier for lenders to let a borrower pay off a mortgage ahead of schedule without being penalized.

One disadvantage for borrowers: Some homebuyers might find it tough to qualify for a mortgage because of the tight standards mandated for loans that'll be sold on the secondary market.

Frequently Asked Questions

Primary Points About the Secondary Mortgage Market

To many borrowers, the secondary mortgage market is invisible. But borrowers should pay attention to the secondary market, as it frees up money for more home loans, helps lower interest rates, may affect how your loan is serviced and helps stabilize the overall housing market.

While the inner workings of the secondary mortgage market might be hard to grasp, homebuyers would be wise to get up to speed about how the market benefits them.