Just like any market for securities, the value of mortgages on the secondary market depends on their risk and potential return. Higher-risk loans must offer higher returns, which is one of the reasons that people with lower credit scores pay higher interest rates.

Primary vs. secondary mortgage market

The primary mortgage market is where borrowers get mortgages from lenders. For example, if you go to a local credit union and a couple of banks to get a quote for a mortgage, you’re participating in the primary mortgage market.

The secondary mortgage market doesn’t involve borrowers at all. Instead, it’s where lenders sell loans they’ve originated to investors.

How the secondary mortgage market works

After making a loan, a lender often sells it in the secondary mortgage market, though the lender may retain the servicing rights. Many lenders sell loans to the government-sponsored enterprises Fannie Mae and Freddie Mac or other aggregators, who can repackage the loans as mortgage-backed securities, or MBS, or hold them on their own books and collect the interest from borrowers.

To be sold to the agencies, the loan must be “conforming” — that is, the loan must meet certain standards set by the agencies. These factors include:

• A maximum loan amount of $726,200 (for 2023) in most markets, though it is higher in others
• The down payment relative to the loan’s size, typically at least 3 percent
• The borrower’s credit score, usually at least 620 to 650
• The borrower’s debt-to-income (DTI) ratio, which should ideally be 36 percent or less

The demand for conforming loans helps push down the mortgage rates for borrowers who can meet the standards. Note that jumbo loans, which are larger in loan size, are not considered conforming loans.

Who is involved in the secondary loan market?

There are several parties involved in the secondary loan market, including:

• Mortgage loan originators (MLOs): MLOs work closely with borrowers to create loans. Later, they may choose to sell these loans on the secondary mortgage market.
• Aggregators: Government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, are aggregators that purchase mortgages from lenders and repackage them into mortgage-backed securities to be sold on the secondary market. MLOs may also act as aggregators.
• Investors: Investors buy mortgage-backed securities on the secondary market. As borrowers repay their loans, investors see returns.
• Homeowners: Homeowners aren’t directly involved in these transactions. However, they’re still an important piece of the puzzle because their loans are what’s being bought and sold on the secondary real estate market.

Why does the secondary mortgage market exist?

Congress created the secondary mortgage market in 1938 with the formation of Fannie Mae, which purchased FHA mortgages. Fannie Mae provided liquidity for originating lenders, who didn’t want to tie up their capital for long periods, and allowed them to generate more loans. With the ability to sell loans, banks could write more mortgages and encourage homeownership.

In 1970, Congress created Freddie Mac with similar goals to Fannie Mae.

Creating a completely new security from mortgages is a complex process, so why would the players involved in the mortgage market do this? The secondary market creates benefits for each economic player — including borrowers, investors, banks/lenders, aggregators and rating agencies.

Because it allows lenders to slice up their mortgages, the secondary market also enables financial firms to specialize in various areas of the market. For example, a bank may originate a loan but sell it in the secondary market while retaining the right to service the mortgage.

As a loan originator, the bank underwrites, processes, funds and closes the loan. It collects fees for these services and then may or may not hold onto the loan.

As a loan servicer, the bank receives a fee for processing the monthly payment, tracking loan balances, generating tax forms and managing escrow accounts, among other functions.

Even if the lender decides to originate the loan and keep it, the lender benefits by having an active and liquid secondary market, where it can sell its loans or servicing rights.

Pros and cons of the secondary mortgage market

Advantages and disadvantages of the secondary mortgage market include:

Pros

• Lower costs: Borrowers can potentially benefit from lower costs because of the secondary mortgage market.
• Investors can pick and choose loans: Investors (including institutional players such as banks, pension funds and hedge funds) get exposure to specific kinds of securities that better meet their needs and risk tolerance.
• Keeps money moving: Lenders can move certain loans off their books, while retaining other loans that they’d prefer to keep. It also allows them to use their capital efficiently, allowing them to generate fees for underwriting mortgages, sell the mortgage and then use their capital again to write a new loan.
• Aggregators collect fees: Aggregators such as Fannie and Freddie earn fees from bundling and repackaging mortgages and structuring them with certain attractive characteristics.

Cons

• Can come with risk: Mortgage-backed securities can be a risky investment. If borrowers default on their loans, investors could lose money, and the economy could take a hit.
• Impact on returns: Investors’ returns can also be negatively affected if a borrower refinances or pays back their loan quicker than expected.
• Strict eligibility criteria: GSEs have strict criteria for what types of loans they’ll guarantee in the secondary market, so lenders usually won’t issue loans outside of these parameters. As a result, borrowers with poor credit scores may not qualify for a loan, or if they do, they’ll likely face higher interest rates.

Bottom line

Because it purchases a huge portion of home loans, the secondary market drives a lot of the behavior in the primary market, such as the banks’ desire to write conforming loans. While you may continue to make your monthly payment to the bank that originated your loan, the money may actually be going to many different investors who own your mortgage or a slice of it.