The U.S. mortgage market is massive, standing at $11.05 trillion in value in 2020.
Consequently, it’s no surprise a financial sector that large is actually composed of multiple main pillars—the primary and secondary mortgage markets.
Why are there two major mortgage markets? Basically, the markets serve separate needs for the homebuying public and the investors who steer money into the U.S. mortgage market, as follows:
Primary mortgage market. The primary mortgage market serves homebuyers, or more “home mortgage borrowers,” by linking those borrowers to home-loan mortgage lenders.
Secondary mortgage market. The mortgage secondary market serves a different purpose. It exists to allow investors to invest in mortgage loans that already exist, in hopes of earning a return on their investment in the process.
The differences between the primary and secondary markets don’t stop there.
Let’s take a look under the hood and compare and contrast the primary and secondary mortgage markets.
What is a Primary Mortgage Market?
Think of the primary loan market as anytime a homebuyer borrows a mortgage directly from a lender. According to the National Association of REALTORs®, 13% of homebuyers paid all cash for a home purchase in 2018. The remaining 87% financed their purchase, generally in the form of a primary mortgage.
This is where the primary mortgage market comes into play.
Homebuyers and refinancers can get a primary mortgage loan at a variety of sources, including:
• Banks and credit unions. Banks and credit unions are the two of the most common sources of mortgage loans.
• Mortgage brokers. While not technically a mortgage lender, a good mortgage broker can find good mortgage lending sources for home buyers and refinancing consumers. That access to so many lenders makes a mortgage broker another mechanism for finding a mortgage.
• Online lending platforms. Online financial companies offer home loans to borrowers, and may offer lower interest rates and fees than traditional lenders, as they don’t have to pay for brick and mortar lending locations. This isn’t always the case, so it can be helpful to review options available to you at a variety of lenders.
What is a Secondary Mortgage Market?
With the secondary mortgage market, investors can “buy in” to mortgage loans that have already been originated, and try to earn a profit on those resold mortgage loans.
For banks and other primary lenders, selling mortgages is a common practice. This allows them to replenish their capital and continue making loans to other potential borrowers.
There are several secondary mortgage loan organizations that buy mortgage loans and resell them to investors. Some of these organizations include:
The Federal National Mortgage Market (also known as Fannie Mae or FNMA). Fannie Mae is one of the biggest providers of mortgage loans in the secondary mortgage loan market. While FNMA is backed and supervised by the U.S government, it’s a for-profit company, making it unique among secondary mortgage loan organizations. It purchases loan notes from a wide variety of mortgage lenders.
The Government National Mortgage Association. Also known as Ginne Mae or GNMA, this organization is U.S. government owned and operated. It mostly buys mortgage loans from government lenders like the Federal Housing Administration (FHA) or the U.S. Veterans Administration (VA).
The Federal Home Loan Corporation. Also known as Freddie Mac, this organization is as pervasive in the secondary loan market as Fannie Mae. Yet as a similarly private company, Freddie Mac buys up loan notes from financial institutions—mostly from savings and loans companies.
An Example of the Two Markets in Action
The primary mortgage market sets the tone for all home loan activity.
Let’s say an individual—“Borrower 1”—decides she wants to buy a home and needs help in financing the purchase.
Borrower 1 must get that mortgage loan from a reputable mortgage lender, which most likely found in the primary mortgage loan market, where home loans originate.
Borrower 1 shops around for a good mortgage loan option with a solid interest rate and low fees and costs attached. She finds such a loan, applies for that loan, and is approved for a mortgage loan.
Borrower 1 goes on to purchase the house and moves into her new home. Her loan however, shifts into another phase—into the secondary mortgage market.
Several months after closing the loan and moving into her home, Borrower 1 gets a letter from her mortgage lender stating that her mortgage loan has been sold to another financial entity.
Now, she must now steer her monthly mortgage payments to the new loan buyer.
The new buyer, which may be an investor or mortgage loan aggregator (i.e., a firm or group who buys multiple mortgage loans and turns them into an investment vehicle) buys the loan on the secondary mortgage loan market.
Once purchased, the new mortgage loan buyer packages the mortgage loan vehicle into what financial markets call mortgage backed securities, and offers them to investors. That scenario is much like a mutual fund bundles different stocks together and offers them on the open market to retail and institutional investors.
Basically, any investor who engages with the secondary mortgage market is buying Borrower 1’s mortgage debt, along with multiple other primary mortgage loan debts, and counts on all the primary mortgage borrowers to pay off their mortgage debt, with the investor pocketing a percentage of the profits.
Secondary mortgage loan investments are a good deal when the primary loan consumers (like Borrower 1) pays down their mortgage debts. If not, and the primary loans go into default (much like they did in the Great Recession in 2008-and-2009) the secondary mortgage loan investor may lose a lot of money on the investment.
Advantages and Disadvantages of Primary Mortgage Loans
Both primary and secondary mortgages have their upsides and downsides. It’s important to remember how the two markets differ.
The primary mortgage market describes the mortgages that are made between the borrower and the mortgage lender. Let’s dive a bit deeper into the advantages and disadvantages.
Advantages of the Primary Mortgage Loan Market
Primary loans are plentiful
Since primary mortgage loans are so abundant on the mortgage loan marketplace, mortgage consumers have a wide array of loan choices from banks, credit unions, savings and loans, mortgage brokers, and online financial institutions.
Multiple loan options
Primary mortgage lenders usually offer a variety of loan options for consumers. The main options include fixed-term loans for 15-or-30 years, where loan rates are locked in for the duration of the loan.
Primary mortgage market lenders may also offer adjustable rate mortgage loans, in which loan rates are fixed for a specified period of time (such as five or seven years, for example).
After that time period, an ARM mortgage rate can change over time, giving home borrowers more flexibility, depending on their unique household financial needs.
Disadvantages of the Primary Mortgage Loan Market
Here are some of the disadvantages of the primary mortgage market for home-buyers.
Borrowers have to be vetted, credit-wise
Primary mortgage loan lenders will usually review a potential borrower’s credit score in order to determine their eligibility for a loan.
Applicants with a less-than-ideal credit score, may find it challenging to secure a mortgage. Additionally, mortgages that are backed by the federal government, like FHA Loans, generally have strict qualification requirements.
Missed mortgage loan payments can have negative impacts
Primary market loan borrowers who miss payments or default outright may face significant penalties, such as incurring late fees, a plummeting credit score, or even foreclosure on the home.
The Advantages and Disadvantages of the Secondary Mortgage Loan Market
When primary lenders sell the mortgages they’ve made to investors, those mortgages enter the secondary loan market. This is a common practice in the mortgage industry.
Here are a few of the disadvantages when it comes to the secondary loan market.
Advantages of the Secondary Mortgage Loan Market
Dependable rate set-up for investors
With secondary mortgage market deals, investors can generally expect to earn a more competitive interest rate than government bonds.
Abundant buying options
Investments in mortgage backed securities, created through the secondary market can be made through a host of reliable organizations, some of which are backed by the U.S. government.
Options include Fannie Mae, Freddie Mac, Ginnie Mae, and some private institutions such as brokerage firms.
Disadvantages of the Secondary Mortgage Loan Market
Not for the average American
Common buyers of secondary mortgage loans include deep-pocketed financial organizations like insurance companies, mortgage banks, and pension funds, who become the new mortgage lenders.
Mortgage backed securities can be complex investment vehicles, and as such, may not be a realistic investment option for Main Street Americans.
While investors may earn a competitive rate on these securities, there are some risks associated with them. Risks include credit and default risk, should the underlying mortgages be in default.
Securities backed by federal organizations including Ginnie Mae, Freddie Mac, and Fannie Mae have certain federal guarantees which can help mitigate some of the risk associated with this.
Private label mortgage backed securities are those offered by private companies and are not backed by the federal government.
Additionally, when the underlying mortgages are prepaid or refinanced, this can impact the returns an investor sees.
Investors won’t see the properties attached to the mortgages
Secondary mortgage loan buyers usually won’t physically see and assess the properties attached to the mortgages they’re buying.
In order for primary loans to be sold into the secondary market, they must meet certain requirements; including lending limits, guidelines for the loan-to-value ratio, and the borrower’s debt-to-income ratio.
Loans that meet requirements are called “conforming” loans.
The Takeaway on Primary and Secondary Mortgage Loan Markets
The primary mortgage loan market and the secondary loan market generally work well together.
The former gives borrowers access to funds to buy their dream home and the latter allows banks to replenish their funds by selling the mortgages they’ve brokered to financial institutions like Freddie Mae, Fannie Mac, and Ginnie Mae, or some private firms.
Then, these mortgages are structured into mortgage-backed securities.
That may be viewed as a win-win proposition—as long as both parties live up to their financial obligations.
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