The Basics of the Mortgage Market

Written by
Kara Johnson
Read Time: 5 minutes

The mortgage market can be a confusing place to do business, especially for those who don't understand its basic structure. There are three major sectors of the market; knowing what they are and the roles they play can help you better understand how the mortgage business works.

This sort of knowledge is helpful when you're shopping for a mortgage because the way mortgages are structured and priced is directly related to how they fit in with these three sectors. Knowing about them will help you make sense of what your lender is telling you, rather than rather than being just a bunch of meaningless terms

Conforming and Non-Conforming

Mortgages for a home purchase or refinance fall into one of two categories: "conforming" and "non-conforming." Generally speaking, a conforming loan is one that meets the standards set by various government-affiliated enterprises that back consumer mortgages -they "conform" to those standards. Those that do not are non-conforming. Simple, right?

The term "conforming loan" is generally used to refer to mortgages that meet the underwriting guidelines set by Fannie Mae and Freddie Mac, two technically private enterprises that were originally created by the federal government but currently operate under the authority of the Federal Housing Finance Agency (FHFA). The term is less commonly used for mortgages that meet the guidelines of the FHA, VA and USDA Rural Development, but still applies there.

The reason conforming loans are a big deal is that they are almost always cheaper than non-conforming mortgages and are usually easier to obtain as well. The reason is that the agencies backing them will offer certain guarantees on mortgages that meet their underwriting guidelines, which reduces the risk to lenders and enables them to offer lower interest rates and fees.

The guidelines for conforming loans cover a variety of criteria, including credit scores, down payments, debt-to-income levels, income verification and more. The big one, though, is the cap on the loan amount (loan limit). In most of the U.S., the most you can borrow with a conforming mortgage is $647,200, though in counties with high real estate values the limit goes as high as $970,800.

Non-conforming loans are generally riskier for lenders to make and so their interest rates and fees tend to be higher. Mortgages in excess of $$647,200 - $970,800, depending on the county, are called jumbo mortgages, which are a special type of non-conforming loans used to buy higher-priced properties.

When a lender talks about a non-conforming loan, they're generally talking about a mortgage that exceeds these loan limits. However, a loan can be non-conforming for other reasons as well, such as low credit score, high debt or loan-to-income ratios, lack of income verification or the like.

While non-conforming loans tend to be more expensive, they also have less restrictive criteria for applicants. So if you're denied a conforming loan, the relaxed requirements of the non-conforming variety may make it easier for you to obtain one.

Primary and Secondary Markets

Here's something you may not have known. Most mortgage lenders do not make money off the interest charged on the loans they write. They earn their money on the fees charged up front and then sell the loans to investors as bonds or securities, who are the ones who profit from the interest. The lenders then turn around and use that cash to make more loans and earn more fees.

The lenders who originate loans with borrowers are called the primary mortgage market. The sale of mortgage-backed bonds and securities to investors is called the secondary mortgage market.

This is where Fannie Mae and Freddie Mac come back into the picture. They not only provide certain types of guarantees for loans that meet their guidelines, they also bundle them for sale as securities on the secondary market. The Government National Mortgage Association, known as Ginnie Mae, does the same thing for FHA and VA loans.

Non-conforming mortgages can be sold on the secondary market as well. However, without the guarantees provided by the government-affiliated agencies, lenders demand a higher return, which is one of the thing that makes such loans more costly.

Not all lenders sell their mortgages on the secondary market. Some keep the loans on their books and rely on the interest generated to earn their profits. Some small banks, credit unions and nonbank lenders will do that. This allows them to set their own standards for the loans they underwrite, free of the rules of the secondary market, and can make them more flexible in the loans and terms they offer.

Institutional and Private Lenders

Lenders are either of the private or institutional stripe. Commercial banks, savings and loans, and credit unions are all institutional lenders. When you borrow from them, you'll be qualified according to industry guidelines, and the mortgage will be based on factors that include your credit score, income, and household expenses.

Private lenders are individuals or corporations who aren't obligated to follow federal government guidelines. Their loans are not government-insured, and they often lend money in such a way that doesn't reflect the guidelines of institutional lenders. This is often called private money lending.

Private lenders usually cater to customers with special needs or who can't qualify for a mortgage through an institutional lender. These may include wealthy individuals looking to fund the purchase of a multimillion-dollar home using creative financing, business owners whose earnings are tied up in their enterprises and so are difficult to document for purpose of a loan, individuals who do not wish to disclose certain aspects of their personal finances, persons who have made a quick recovery from bankruptcy but can't yet qualify for a conventional mortgage and others.

Once you know where to begin your search for the fundamental types of mortgage loans, you can narrow down the search based on rates, fees, and what type of mortgage terms you prefer. You'll find that mortgages will no longer be a mystery.

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