The Pot of Gold

Image by beluga 7 via Flickr

There are two reasons why a bank or mortgage company might make a residential mortgage loan:

• To earn the interest that is paid over the life of the mortgage
• To earn fee income from the origination and sale of the mortgage

At current interest rate levels, most mortgage borrowers want a 30 year fixed rate mortgage. Most banks do not want to lend their money at fixed rates for 30 years. That is because the money that the banks have to invest in that mortgage is from their depositors who, on average, have deposited the money for only about 3 years. The bank makes money on the spread – the difference between the rate on the 30 year mortgage and the rate that they pay the depositors. If the bank lends the money out for thirty years, and the depositor wants their money back after three years, the bank has a problem. In order to give the depositor their money back, the bank either has to sell the mortgage or take in new deposits at whatever deposit rates then exist.

If deposit rates have gone up, the rate on the 30 year mortgage stays fixed and the difference – the bank’s profit spread – goes down. If the bank tries to sell the mortgage, the value of the mortgage has gone down because current interest rates are higher than the rate at which the mortgage was made.

For that reason, most banks are willing to make 30 year mortgages, but they immediately sell those mortgages. They are willing to make the mortgages because they can earn fee income from the origination of the mortgage.

Who buys the mortgages? I will cover that in the next posting.