What it means
When a company services a mortgage, it collects payments, passes money to investors and handles problems. For this work it receives a servicing fee, which is usually a fraction of the loan balance each year.
If the borrower's interest rate is higher than the rate paid to investors plus a normal servicing fee, there is some interest left over. That leftover is the excess servicing.
It is sometimes called an excess servicing strip or an interest-only strip, because it is paid out of interest alone with no principal attached. A lender can keep this strip when it sells the loans, or sell the strip itself for cash.
Valuing excess servicing is all about how long the loans stay in place. The strip is paid only while the loans are outstanding, and it is calculated on the shrinking balance.
If borrowers refinance or move, the loan is repaid, and the strip stops paying. This makes it sensitive to interest rates.
When rates fall, more borrowers refinance, loans disappear faster, and the strip loses value, whereas rising rates tend to extend the life of loans and increase its value. Accountants must estimate prepayments carefully and revisit those estimates.
In financial reporting, the treatment of excess servicing has rules about whether income is recognised when the loans are sold or over time. Finance teams should confirm the policy with their auditors, as the accounting can change reported profit.
Hedging and regular revaluation are the usual ways to manage the risk. Holders compare actual prepayment speeds with their forecasts each quarter and adjust the carrying value of the strip when the picture changes.
Buyers of strips also pay close attention to the credit quality of the underlying borrowers, since loans that default stop paying altogether.
In practice
Real-world examples.
Example
A mortgage company sells a pool of loans but keeps a 0.25% excess servicing strip. Each month it receives its share of interest from the pool. It records the strip as an asset and tests it regularly for changes in expected prepayments. The accounting team documents the assumptions each quarter so the auditors can follow the numbers.
Example
An investment firm buys excess servicing strips from several lenders. It expects rates to stay high, which will keep borrowers from refinancing and keep the strips paying for longer. The firm earns a steady income, though it knows a sharp drop in rates would hurt.
Example
A lender needs cash quickly to fund new loans, so it sells its excess servicing strip for $1,100,000. The buyer takes over the stream of interest payments. The lender gets cash today instead of waiting for income over several years. It uses the money to fund 3 more loans that month, which earn it fresh origination fees.
Formula
Calculation
Excess Servicing Rate = Borrower Rate - Investor Pass-Through Rate - Normal Servicing Fee
Annual Excess Servicing Income = Pool Balance x Excess Servicing Rate
Suppose a pool of loans has a balance of $100,000,000 and a borrower rate of 6.5%. Investors are paid a pass-through rate of 6.0%, and the normal servicing fee is assumed to be 0.25%. Excess Servicing Rate = 6.5% - 6.0% - 0.25% = 0.25%. Annual Excess Servicing Income = 100,000,000 x 0.0025 = $250,000 in the first year, and it falls as the balance shrinks.Case study
Seen in the real world.
Falconridge Mortgage is an illustrative, fictional lender that kept a 0.25% excess servicing strip on $400,000,000 of loans. The strip earned about $1,000,000 in its first year, and the finance team valued it assuming loans would last an average of seven years.
When interest rates fell, borrowers refinanced faster, and the expected average life of the loans dropped to four years. The strip's value fell, and the company had to take a write-down on its balance sheet.
Management responded by hedging part of the exposure and pricing its next loans with this risk in mind. The illustrative lesson is that excess servicing looks like steady income, but its value depends heavily on how quickly borrowers repay.
Watch out
Common mistakes.
- Treating the strip as guaranteed income, when it stops as soon as the underlying loans are repaid.
- Ignoring falling interest rates, which speed up refinancing and shorten the life of the strip.
- Confusing excess servicing with the normal servicing fee, when the normal fee pays for the work and the excess is the amount above it.
Questions
People also ask.
What is a normal servicing fee?
It is the standard fee a servicer receives for collecting payments and managing loans, often a small fraction of the balance each year.
Why can excess servicing be sold?
Because it is a stream of cash flows with a measurable value, so buyers can price it based on expected loan lives.
How does it differ from mortgage servicing rights?
Servicing rights cover the right and duty to service loans for a fee, whereas the excess portion is the extra interest above a normal fee.
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