When you are ready to get a home loan, chances are that you will head to the nearest bank and apply for a mortgage. Understanding how banks work, at least in general terms, is a good idea if you want to understand more about the mortgage process.
Bank deposits and loans
The idea behind a bank is that it is a safe place to keep your money. Most of us wouldn’t want a large amount of money sitting in the house; it would make us targets for thieves. Keeping money in a bank can ease many transactions, and you generally feel comfortable with the idea that the money is safe. Additionally, in some cases, you can earn a return on the money you leave sitting in the bank.
A bank earns money by taking your money and then lending it out to others as interest. Let’s say you put $10,000 in a savings account. The bank pays you 1% APY to keep your money in the bank. However, that money doesn’t physically stay in the bank. Instead, the bank uses that money to make money for itself. A bank might take $8,000 of that $10,000 of yours and lend it to someone else to buy a car. The bank might charge an interest rate of 5% APR on the car loan, meaning that the bank’s return, after subtracting what it owes you in interest, is 4%.
This is a very simple example to show you how banking generally works. However, it’s important to note that banks can often lend out more money than they have in deposits to back the loans. In fact, banks themselves often borrow from other banks or from the Federal Reserve in order to lend more money to consumers.
One of the reasons that you are paid a higher yield on savings products, such as savings accounts and CDs, is due to the fact that there are limitations on how often you can access your money. The bank knows that it is likely to sit there, and help the balance sheet. Your checking account, however, often fluctuates, so it’s not money the bank can truly count on. That’s why, if you do receive interest on your checking balance, it’s usually a very small amount.
It can be unnerving for some consumers to think about how banks’ balance sheets might work. That’s why the government offers FDIC insurance. Banks pay premiums to the FDIC, and the FDIC, in turn, guarantees that consumers can get their money, up to certain limits, from a bank if the bank fails. The idea is to help maintain faith in the banks and the banking system so that we don’t end up with a complete loss of confidence, as what happened during the Great Depression and other banking scares in the early 1900s and the 1800s.
Banks borrow from others
Banks don’t just rely on the deposits they have from savers to make loans out to others. If you look at how much people generally save, and compare that to how much is being borrowed, it’s easy to see that it would be difficult for banks to lend enough to meet demand if all they did was rely on their supplies of deposits.
Instead, banks borrow from others, as well as relying on the money that consumers entrust to them. Banks can borrow from each other, and from the Federal Reserve, at very low rates. The expectation is that the bank will then go out and lend more money to consumers. If a bank can borrow money from the Federal Reserve at 0.25% and then lend it to a home buyer at 3.75%, the bank still makes a decent enough return on the money.
Here are two of the ways that banks can borrow in order to lend more to consumers:
Warehouse line of credit: Most bank borrow from others on a short-term basis. A warehouse line of credit is a short-term line of credit that a mortgage banker can draw on to fund purchases of mortgages. There are a number of mortgage lenders that rely more on warehouse lines of credit than they do on bank deposits, since there are lenders that don’t operate as retail banks.
When a mortgage lender draws on the warehouse line of credit, the term lasts until the loan is paid off. The mortgage note acts as collateral. The mortgage lender can keep servicing the loan, or the lender can sell the loan on the secondary market or to someone else. Warehouse lending is a vital part of the mortgage loan industry, since it frees up capital to keep moving through the system, allowing borrowers to buy homes. This increased capacity is one of the reasons that it’s possible for first-time homebuyers to make purchases, and why it’s possible for struggling homeowners to refinance their loans.
Repurchase and reverse repurchase: These are transactions that often take place via the Federal Reserve. The idea is that a dealer can buy government securities now and then sell them again the next day. Repurchase agreements are those in which the dealers receive collateralized loans from the Federal Reserve. A reverse repurchase is one in which the Fed borrows from dealers.
In most cases, the term is overnight, although the terms can be longer. The main point of these types of transactions is to offset bank reserve swings. That way, banks and other financial institutions can manage the swings in their reserves so that they remain at an acceptable level with regard to how much is outstanding. You can learn more about these types of agreements from the Federal Reserve Bank of New York.
As you might imagine, mortgage rates can be influenced by all of this action. Treasury bills are generally used as collateral in the Fed transactions, so it makes sense that Treasury rates can influence mortgage rates. Additionally, spreads between what a mortgage banker pays to a warehouse lender, and what the lender can receive from borrowers also matter.
By paying attention to what is happening with mortgage rates, and understanding some of the factors that influence mortgage rates, it’s possible to determine when the best time for you to buy a home might be.