What it means
Most mortgage lenders originate a loan and then sell it to a larger institution or an investor, which packages many loans into securities. To sell loans in this way, lenders follow standard rules about income, credit scores and property type.
A portfolio lender skips that step and holds the loan until it is repaid, so it follows its own policy. This gives the lender flexibility.
It can lend to self-employed people with irregular income, finance unusual properties, offer interest-only periods or take account of a borrower's overall relationship. The trade-off is that the lender carries all the credit risk, so it prices that risk into the rate or fees.
For borrowers, portfolio lenders can be a route when the standard route is closed. Typical customers include business owners, property investors, buyers of mixed-use buildings and people who have recently changed jobs.
The rates are sometimes higher, and terms such as balloon payments (a large final payment) or prepayment penalties may apply, so careful reading is important. For the lender, the loan is an asset that earns interest income, funded by deposits and other borrowing.
Profit comes from the gap between the interest earned and the cost of funds, less operating costs and credit losses. Because the loans stay on the balance sheet, regulators require the lender to hold capital against them.
Community banks, credit unions and smaller savings institutions are the most common portfolio lenders, because they know their local markets and customers. Their knowledge allows judgement-based decisions that a rigid formula would not permit.
Risks include concentration, since a lender with many loans of one kind in one area is exposed to local downturns, and liquidity, since the loans cannot easily be sold if the lender needs cash. Sensible lenders manage these risks with limits and regular reviews of the portfolio.
In practice
Real-world examples.
Example
A self-employed designer with strong but uneven income is refused a standard mortgage. A local credit union acts as a portfolio lender, looks at three years of bank statements and approves the loan. The credit union accepts the extra judgement work because it keeps the customer and earns the interest.
Example
A property investor wants to buy a building with shops below and flats above. A community bank keeps the loan on its books, because the property does not fit the rules of the large lenders. The bank charges a slightly higher rate and asks for a larger deposit to reflect its risk.
Example
A bank analyst reviews the loan book and finds that 40% of loans are secured on one town's office buildings. The bank sets a limit on new lending there to reduce concentration risk. The limit protects the bank if office values fall in that town.
Formula
Calculation
Annual net interest income on a loan = loan balance x (loan rate - cost of funds)
Suppose a portfolio lender makes a $500,000 loan at 7% and funds it at a cost of 4.5%.
Interest earned = 500,000 x 0.07 = $35,000 a year.
Funding cost = 500,000 x 0.045 = $22,500 a year.
Net interest income = 35,000 - 22,500 = $12,500, which equals 500,000 x (0.07 - 0.045) = 500,000 x 0.025.
From this $12,500 the lender must still pay operating costs and cover any credit losses.Case study
Seen in the real world.
Riverbend Savings is a fictional community bank that acts as a portfolio lender. In this illustrative case, a local bakery owner asks for a $300,000 loan to buy the shop she rents. Large lenders have declined because her income varies with the seasons.
The bank's loan officer reviews five years of accounts and visits the shop. She approves the loan at 7.5% with a modest prepayment penalty, and the bank earns 300,000 x (0.075 - 0.045) = $9,000 a year in net interest before costs.
The loan performs well, and the owner later uses the bank for her business accounts. The bank's board notes that knowing the customer allowed it to lend safely where an automated process could not, and the loan becomes a good example for training other loan officers.
Watch out
Common mistakes.
- Assuming a portfolio lender is always more expensive. The rate depends on the borrower's risk, and local lenders can sometimes be competitive.
- Ignoring loan terms. Balloon payments and penalties can be unexpected if the contract is not read carefully.
- Forgetting that the lender bears all the risk. This is why it may ask for a larger deposit, personal guarantees or extra security over other assets.
Questions
People also ask.
Why do portfolio lenders keep loans?
They earn the interest over time and gain the freedom to set their own lending rules.
Who benefits most?
Borrowers whose circumstances do not fit standard rules, such as the self-employed or buyers of unusual property, and those who value a lender who knows their local market.
How is a portfolio lender different from a mortgage broker?
A broker arranges loans with other lenders, while a portfolio lender provides the money itself and holds the loan.
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