Discounted mortgages refer to the purchase of an existing mortgage at a price below it’s current principal balance. For example, if a mortgage has an outstanding principal of $40,000, you might be able to buy it for $35,000. If you then find an investor willing to pay $37,000 for it, the $2,000 difference represents your profit.
When you buy a mortgage, nothing changes for the borrower — they simply send their payments to you instead of the original lender.
In this Article
Why Do Mortgages Get Discounted?
In the United States, almost every mortgage is sold, usually for close to its face value. Banks and lenders rarely hold onto the loans they originate. Instead, they sell them on the secondary mortgage market, typically to government-sponsored entities like Fannie Mae or Freddie Mac, which play crucial roles in the housing finance system.
How Do Fannie Mae and Freddie Mac Work?
Fannie Mae
Fannie Mae (Federal National Mortgage Association) was created in 1938 to increase the flow of mortgage funds across the country. Initially, it purchased mortgages insured by the Federal Housing Administration (FHA). Over time, its role expanded, and in 1968, it became a private, shareholder-owned company. Fannie Mae buys mortgages from lenders and packages them into mortgage-backed securities (MBS), which are sold to investors. This process replenishes lenders’ capital, enabling them to offer more loans to homebuyers.
Freddie Mac
Freddie Mac (Federal Home Loan Mortgage Corporation) was established in 1970 to support the mortgage market by purchasing loans from lenders, similar to Fannie Mae. Freddie Mac also pools mortgages into MBS, providing liquidity and stability to the housing market. Like Fannie Mae, Freddie Mac guarantees timely payment of principal and interest to investors in their MBS, making them attractive for their stability.
Selling Your Mortgage at a Discount
While banks and large financial institutions sell mortgages to entities like Fannie Mae and Freddie Mac at full value, individual sellers who offer seller financing — where the seller acts as the lender — are often asked to sell their notes at a discount.
When you sell a mortgage, note buyers may offer you less than the mortgage’s face value, using arguments related to the time value of money. They’ll explain that money today is worth more than money tomorrow, and because mortgage payments can extend over 30 years, they might insist the mortgage is worth less than the full value.
What Note Buyers Might Tell You
A common tactic note buyers use is the “time value of money” argument. They might say, “A dollar today is worth more than a dollar in the future.” While it’s true that waiting 30 years to get your money reduces its present value, the reality is that most mortgages don’t last that long — they’re typically paid off within 7 years, either through refinancing or selling the property.
Note Buyers may present examples like this:
- “Would you rather have $100 in a year or $10 today?”
- “What if you had to wait 30 years for that $100?”
This argument is designed to convince you that your mortgage is worth much less than its face value.
Your Response to the Time Value of Money Argument
When confronted with this argument, here’s how you can respond:
“I’m confused. When I got my 30-year mortgage from my local bank, they sold it to Fannie Mae. Are you suggesting that they sold it for less than what I borrowed? Why would they do that?”
This counterargument highlights the fact that large financial institutions sell mortgages at or near full value, not at a discount.
What Happens When a Bank sells a Mortgage
The primary reason a mortgage may be sold at a discount has less to do with the time value of money and more with other factors, even if the mortgage carries a competitive interest rate. To understand why a mortgage might be discounted, let’s look at what happens when a bank sells a mortgage to Fannie Mae or Freddie Mac.
It’s important to note that Fannie Mae and Freddie Mac purchase only from institutional lenders like banks — they do not buy from private mortgage holders. Mortgages that qualify for sale to these entities are known as conventional mortgages and must meet specific standards.
Before a borrower can obtain a conventional mortgage, they must provide extensive documentation to the lender, who in turn needs to ensure the loan comp. lies with Fannie Mae or Freddie Mac’s guidelines. These guidelines ensure that the mortgage is a low-risk investment.
Here are some of the key requirements that institutional lenders need to verify:
- Independent Appraisal: Ensures the property is worth the loan amount.
- Property Survey: Verifies boundaries and checks for encroachments.
- Down Payment: Typically, at least 10% cash down is required.
Documents Required for Conventional Mortgages:
- Credit Reports: For all borrowers to assess creditworthiness.
- Uniform Loan Application (Form 1003): Completed and signed by the borrower.
- Tax Returns and W-2s: For the past two years.
- Pay Stubs: Most recent pay stubs within 30 days.
- Insurance: Evidence of fire/hazard insurance on the property.
- Bank Statements: For the last three months.
- Additional Documentation: Non-citizens need a green card, and income verification may be required for other income sources like alimony, rental agreements, or social security.
Additional Requirements for Property Purchases:
- Purchase Contract: Proof of purchase agreement.
- Landlord Information: For those who have rented in the past two years.
- Condo Details: If applicable, condo information and management contacts.
- Recorded Documents: Any relevant legal documents, such as quitclaims or divorce decrees.
- Employment Gap Letters: Explanation of any gaps in employment over the past two years.
- Gift Letters: Proof and documentation of any gifted funds.
Requirements for Self-Employed Borrowers:
- Corporate and Partnership Tax Returns: For the past two years.
- Profit and Loss Statements: Year-to-date (YTD) financial statements.
- State Tax Returns and Excise Taxes: Proof of payment of state taxes for the current year.
The Closing Process
Once all documentation is gathered and the loan is approved, the closing is typically handled by a title company or an attorney. Standardized documentation ensures the loan can be sold in the secondary mortgage market to investors like Fannie Mae or Freddie Mac. Title insurance is required, and all compliance with lending laws is verified before closing.
Why would a Mortgage Be Discounted?
While institutional lenders can sell mortgages to Fannie Mae or Freddie Mac at full value, private individuals or smaller lenders who hold mortgages, especially those who offered seller financing, may face a discount when selling these loans.
The main Reasons for a Discounted Mortgage Sale include:
- Risk Perception: Buyers of private mortgages may perceive higher risks, especially if the borrower’s financial profile is not as strong as those approved by institutional lenders.
- Lack of Government Backing: Unlike institutional mortgages sold to Fannie Mae or Freddie Mac, which come with government backing, private mortgages do not have this security.
The Mortgage Investor’s Perspective
Fannie Mae and Freddie Mac provide a near-guarantee of payment to investors by purchasing mortgages and bundling them into mortgage-backed securities (MBS). These securities are seen as low-risk investments because of the implicit backing by the federal government, making them as safe as government bonds in many ways.
However, private mortgage buyers don’t have the same government guarantees. Therefore, they often discount mortgages to account for the added risk of non-payment or default. Additionally, private note buyers may argue that the time value of money — the idea that money today is worth more than the same amount in the future — reduces the mortgage’s present value.
Conclusion
In the secondary mortgage market, large institutions like Fannie Mae and Freddie Mac purchase loans from banks at full value, ensuring a steady flow of funds into the housing market. However, individual sellers offering seller financing are often asked to sell their notes at a discount. Understanding the tactics used by note buyers and the true value of your mortgage can help you make better decisions when selling a mortgage. While the time value of money is a valid financial principle, it’s important to recognize that most mortgages are paid off well before their full term, making the actual discount less than what some buyers might suggest.
Further Reading on Discounted Mortgages:
- Seller Financing Advice You Need To Know: SAFE And Dodd-Frank Acts
- Seller Financing: The Typical Features That Make it Unique
- How to use Seller Financing to Maximize your Profit
DISCLAIMER: We are not attorneys and we cannot advise you regarding your particular circumstances. You must always obtain competent legal counsel and financial advice. We believe this information to be accurate, but please check with a qualified real estate attorney in your state before making any decision based on this information.