Finding your best loan option
Mortgage borrowers are often very familiar with FHA, VA, and conventional financing.
However, when it comes to portfolio loans, the situation is not so clear. So, what is a portfolio mortgage, and why should borrowers be interested?
In short, portfolio loans often come with looser rules — rules that individual banks create, not major national agencies. Portfolio lenders can bend the rules for specific, outside-the-box situations.
Tired of being denied? A portfolio mortgage might be the answer to your complex financing needs.
What is a portfolio mortgage?
Portfolio mortgages are loans which are originated by a lender and then held – kept in portfolio – for the life of the loan. This makes them very different from most mortgages.
Imagine that the local Smith Bank has $100 million that it can loan out for mortgages. As it happens, in the local community, the typical mortgage amount is $100,000. Given this information, we know that the Smith Bank can make 1,000 mortgages in the community it serves.
The question that arises is this: after Smith funds its 1,000th mortgage, how does it help the next person who walks through the doors and wants financing? After all, the bank has no more money to lend.
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The answer is that the loans originated by Smith Bank are assets that can be sold. In the case of mortgages, these assets are sold into what is called the “secondary” market, which includes buyers like Fannie Mae and Freddie Mac.
By selling its loans, the Smith Bank is able to get new capital, and therefore create additional mortgages.
Here is a flowchart that demonstrates how the secondary market works.
Portfolio vs. conforming home loans
To sell loans in the secondary market, financing must meet certain standards. FHA, VA, and conventional (non-government) mortgages all come with different sets of guidelines. That’s to protect investors who buy these loans, and often the government agencies that back them.
For example, these loans prohibit balloon payments, generally limit the borrower’s debt-to-income ratio to 43 percent, ban prepayment penalties, and cap the fees that lenders can charge.
However, if a lender keeps mortgages and does not sell them, it does not need to meet the standards that buyers in the secondary market demand. Loans kept on the books — in the lender’s portfolio — can be underwritten to just about any standard, because the lender assumes all the risk.
Why would a lender want to keep a mortgage (put the loan in its portfolio) instead of sell it (unload it on the secondary market)?
- To generate a better rate of return for its money
- It can help a preferred customer who has an outside-the-box financing need
- Charge higher fees for origination.
Why are portfolio loans important to borrowers?
Laurie Goodman with the Urban Institute has this to say about portfolio loans:
“Only the best borrowers are getting loans today, and these loans are so thoroughly scrubbed and cleaned before they’re made that hardly any of them end up going into default.”
Goodman goes on to say, “A near-zero-default environment is clear evidence that we need to open up the credit box and lend to borrowers with less-than-perfect credit.”
It may be that you’re a borrower who is just a touch shy of sailing through the lending system. You really can afford a mortgage. You have enough equity or down payment money.
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However, you don’t quite fit within the standards that most lenders require. In such situations, portfolio mortgages may help.
Because portfolio mortgages are not sold in the secondary market, the lender that originates them can establish looser qualification criteria.
Maybe a 49 percent debt-to-income ratio is okay. Perhaps the lender knows that your credit history has a few excess dings because of medical problems or a divorce, but really you have a good history of repaying debts.
Maybe a lower down payment is okay. Perhaps you’re a foreign national with a financial situation which does not fit within traditional guidelines. Or – with a local bank – maybe you simply have a good long-term relationship.
The list goes on, but the point is this: portfolio mortgages may allow you to get financing which is otherwise unavailable through the regular lending system.
Portfolio loans: Pros and cons
As with all financial products, portfolio loans have both pros and cons. The big pro is the financial flexibility mentioned above.
Portfolio loans may put home ownership within reach, when buying would otherwise not be possible.
At the same time, there may be some drawbacks. For example, a portfolio mortgage might include a prepayment penalty.
This can be a problem if your idea is to finance now and then quickly refinance as your situation improves. The good news is that prepayment penalties today are far less onerous than they used to be, because federal law limits the amounts that lenders can charge and the time frame when prepayment penalties can apply – in essence not more than three years.
Another issue is that lenders may charge higher rates for portfolio loans, because they represent additional risk.
The bottom line: if you’re having trouble qualifying for a mortgage, you might want to consider portfolio financing. Ask lenders if such mortgages are available, and then compare rates and terms.
If you are on the cusp of financing success, but not quite there, portfolio mortgages may give you the extra push you need to get over the goal line.
What are today’s mortgage rates?
Current mortgage rates, including those of portfolio loans, are extraordinarily low. That increases affordability, even if you have to take a more expensive portfolio loan.