In order to be a “direct” lender a company must have its own money. In other words, it cannot have borrowed the funds from any other source and assumed the obligation to pay them back with interest. This fact eliminates all banks, credit unions, savings and loans, mortgage bankers and mortgage brokers.
The truth is that only an investor can be a “direct” lender in the sense that the advertising whiz kids would like you to believe banks are. This is because an investor really does own his money. He has no obligation to pay it back to anyone else. An investor, therefore, has a major advantage over “direct” lenders: he is beholden to no one but himself for the performance of his investments. If he chooses to gamble with risky borrowers, or lend his money out at interest rates that are well below the prevailing market, only he will reap the reward or suffer the loss. If the investor is a company, it is only slightly better off than a “direct” lender. If the company invests its clients’ money poorly—and therefore loses it, or performs poorly in comparison to other investment companies—it will have trouble gaining and keeping clients, and will eventually go out of business. The main difference between an investment company and a bank, credit union, or mortgage banker, is that if it decides to invest in mortgages—and those mortgages go bad, or perform poorly—it has no obligation to make its clients whole.
So, there’s no such thing as a “direct” lender. So, what? What does that have to do with the fact that lenders always sell their loans? It doesn’t seem to make economic sense on the surface. After all, wouldn’t they make a great deal more money by holding the loans and collecting interest over time? Well…yes! And they probably would hold all their loans if it weren’t so risky for them to do so. Allow me to illustrate.
The Financial Risks of Lending
The previous paragraph was a textbook description of how not to run a lending institution; and the same principles apply for all types of mortgage lenders since the money they lend is borrowed in the ﬁrst place. It doesn’t matter where they got it; what matters is that they have borrowed it on short-terms and at variable rates, and lent it out long-term at ﬁxed rates (or at variable rates that cannot change as often, as quickly, or to such extremes as those at which they borrowed). Banks, savings and loans, credit unions, are all required to give their depositors their money on demand; therefore, they are extremely subject to market ﬂuctuations of the type described above. If economic pressures shift and “Bank Of The Cosmos” cannot pay competitive rates, its depositors will take their money elsewhere. Meanwhile, the bank cannot demand its mortgage customers pay back all their loan principle whenever the bank may need it. The same thing applies to money borrowed from the Federal Reserve, and also to the terms under which banks lend money to mortgage bankers.
So, why do mortgage lenders make sure they have a ready, willing, and able buyer for all their loans before they make them? Because they don’t even want to come close to ﬁnding themselves in the situation of “Bank Of The Cosmos.” It is much safer for them to act as middlemen, who take their proﬁt at the time the loan closes, and to leave the risk-taking to investors. Nonetheless, you don’t hear them shouting to the world about how it all works. This is because the marketing magicians have ﬁgured out that borrowers like “direct” lenders—and besides, why would you care anyway? Well, the answer to that question is what I am hoping to make clear to you. But we’ll get into that a bit later. For now, just remember that mortgage lenders don’t own the money they lend. Therefore, your loan will be sold, your lender will be earning his proﬁt at the time of closing (on something other than interest), and you will be paying a commission and fees in one form or another. I will be helping you to ﬁgure out exactly how much you’re paying, and how the lender is collecting it; it will be your job to determine whether that amount is fair in your case.
But before we get into that, for the sake of clarity, I must point out one more thing. In the last section, I stated that “…nearly all [lenders] will sell the residential loans they make…” The exception to that rule is called a “portfolio” lender—although, it is not a true exception, because these companies still borrow the money they lend from their depositors/clients, and still sell the loans they make into the secondary mortgage market. The difference is that they keep them for a while ﬁrst. Once they’ve become “seasoned” (usually after about two years or so, when the questionable borrowers have proven that they can and will pay back the debt), the loan becomes acceptable to the secondary mortgage market, and it is then sold. Portfolio lenders are the “Banks Of The Cosmos” in the real world; for the most part, they consist of small to medium sized companies that have a loyal clientele and a speciﬁc niche. The clientele may be depositors who wish to get a higher (albeit a bit more risky) return on their savings accounts, or the niche may be loans for commercial buildings, or unique properties, etc. Paradoxically, the most commonly known portfolio lenders (though, not nearly as numerous) are gigantic commercial banks or savings and loans. They can be easily identiﬁed by their above-market pricing, and their penchant for pushing variable rate loans. There are advantages to using a portfolio lender if you are the type of borrower who is not easily categorized as "Conforming" (i.e., you’re self-employed, have a marginal credit history, etc.), because the portfolio lender does not have to comply with secondary mortgage market underwriting guidelines at the time you apply. It must, however, cater to the higher cost of its clientele (depositors expecting higher rates on their savings/investment accounts). Therefore, the trade-off will always be higher cost to you and usually the requirement that you accept a variable rate loan, which helps lower the risk for the lender of ending up like Bank Of The Cosmos. The portfolio lenders of the world are becoming increasingly rare due to huge reserve requirements, higher default rates, and other factors that eliminate smaller companies from this niche; and a complete discussion of the pros and cons of using a portfolio lender is beyond the scope of this book. However, the principles I discuss herein are designed to arm you with the knowledge necessary to negotiate a reasonable and fair price for all costs involved with any mortgage transaction, regardless of the type of lender or loan product. So, remember, Caveat Emptor does not apply to institutions, programs, products, rates, and fees--only to people.
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