Why do banks lend money for mortgages?

[TurtleStache]

I've read a lot of post here and on reddit about how it's always mathematically better to invest in the market than pay off a <4-5% mortgage. If that's the case why don't banks invest all of their capital in the market? What makes them lend money at a mathematical disadvantage?

[marty998]

Because banks sell a "product" like any other business. Their product is home loans and business loans.

And it's in their interest (no pun intended) that you take forever to pay off your mortgage too, because the cost of acquiring a new customer to lend that money out is much greater than passively collecting a portion of your pay each month or fortnight.

If a Bank took depositors money and invested it in the stockmarket they'd quickly go broke. A Bank survives on its ability to hedge out interest rate risk (lock in a rate paid to depositors, and lock in a rate received from mortgagers, and profit from the spread).

Not all of the banks assets are "invested" in low rate products. Credit cards are where the real easy money is made.

[Travis]

A couple reasons.  The first is that's where they get capital from.  A bank could invest in the market and rely on just savings account depositors, or they can offer other services that will bring in money to invest. The second is levels of risk.  They can take your money and loan out a portion of it while holding onto some principle while taking some of your money and investing in the market at the same time.  If you're a good credit risk, then the interest you pay on your mortgage is a safer investment than the stock market might be (with a lower return).

The banks screwed up in the early 2000s by making mortgages to bad credit risks and then investing in those mortgages on the bond market end.

[one piece at a time]

I've read a lot of post here and on reddit about how it's always mathematically better to invest in the market than pay off a <4-5% mortgage. If that's the case why don't banks invest all of their capital in the market? What makes them lend money at a mathematical disadvantage?

In the USA the situation is distorted by taxation. I believe that interest payments there are tax deductible (against income) for home owners.

[NorthernBlitz]

I've read a lot of post here and on reddit about how it's always mathematically better to invest in the market than pay off a <4-5% mortgage. If that's the case why don't banks invest all of their capital in the market? What makes them lend money at a mathematical disadvantage?

I think that's a great question. It makes sense in a place like Canada where most mortgage rates are usually fixed for short periods of time (~ 5 years) and the premium to get longer is usually large. When I lived in Canada, I think that the longest we could fix a rate for was ~ 10 years. Payments were were still calculated using 25 year amortizations, but when your term ended you'd need to get a new mortgage at whatever the current rates were.

I don't understand why American banks are willing to take the risk on a 30 year fixed mortgages (or at least why the premium to lock your rate in for that long isn't higher). They do seem to charge a mortgage origination fee which didn't exist when we were in Canada. This would have been the case for us if we didn't buy our house in cash...but I don't know if we were just kind of getting screwed since we didn't have any US credit history (i.e. high mortgage origination fee and high rate from the few places that would even offer us a mortgage).

My guess is that US banks (1) like having the steady inflows of cash over long periods of time and (2) rates have been falling for 40 years so long term mortgages have made sense over that time frame.

Were 30 year mortgages still available in the US from the 1960s - 1980s when rates were generally increasing?

[MilesTeg]

I've read a lot of post here and on reddit about how it's always mathematically better to invest in the market than pay off a <4-5% mortgage. If that's the case why don't banks invest all of their capital in the market? What makes them lend money at a mathematical disadvantage?

Because when a bank loans you money, it's not money they actually have. Every dollar the bank actually has is loaned out multiple times. Sometimes (stupidly) hundreds of times. This only works out because they have a "guaranteed" income from all the borrower payments. The financial crash in 2008 was because many big banks got very stupid and started loaning out each dollar hundreds of times creating a comically unstable house of cards and when only a very small percent of borrowers defaulted that house of cards fell hard.


For more info, start here:
https://en.wikipedia.org/wiki/Fractional-reserve_banking
https://en.wikipedia.org/wiki/Money_multiplier

[Capt j-rod]

Most banks in America service and sell you the mortgage up front and then immediately sell it to Wells Fargo or Freddie/Fannie... They aren't using their money, they are just selling their image to a customer but the first payment goes somewhere else. Banks are a joke in the US and piss me off. They are essentially a check into cash that waits for you to make a mistake and hammer you with fees. They give you no return for keeping any money there. Other than direct deposit and online bill pay I could honestly care less about a bank.

[dogboyslim]

Banks make money on the difference in the spread between their loan rates and their deposit rates.  That used to be the majority of their income.  They also make money with fees.  Fees for too many ATM withdrawls, fees for talking with a live teller, fees for overdraft, etc.  The way a bank makes the most money is to get you the consumer to put all your financial products with them.  Credit cards, deposits, mortgges everything.  The more you have with them, the more you are likely to stay with them.  The longer you stay, the more they make from loaning out $6.50 - $8.50 for every dollar you deposit, and for collecting fee income from you.

[JumpInTheFIRE]

Until fairly recently, it was against the law for banks to invest their customer's money, commercial banks and investment banks had to be separate.  The laws were passed during the Great Depression as a bunch of banks went bust during this time, some of them due to investments that did poorly in the market crash.  The set of laws to enforce this is generally called the "Glass-Steagall Act" (https://en.wikipedia.org/wiki/Glass%E2%80%93Steagall_legislation), it was effectively repealed in 1999 and many economists believe the repeal was responsible or contributed to the 2008 crash.  I certainly don't want my bank to invest my deposits into risky ventures, even with FDIC insurance.

[Prairie Stash]

Because you're comparing Apples to Oranges. Mortgages are the equivalent of holding bonds. Why does anyone hold bonds, if stocks are the greatest?

In more concrete terms - Glass Steagall Act. https://en.wikipedia.org/wiki/Glass%E2%80%93Steagall_legislation

Legislation was enacted to stop banks from taking deposits and buying securities in 1932. In 1999 parts were repealed. In 2007-2008 the US had a financial crash. For a good chunk of american history, the law prevented banks from investing in the stock market with deposits. Perhaps the economy would grow faster if they did, but the volatility (like 2007-08) would be much higher.

[LWYRUP]

All of these answers plus remember that banks CREATE money.

What does it mean to create money?  Well, a bank that has $10 million in deposits can legally go out and lend $100 million (I don't know the exact numbers, just rounding for clarity). 

When you go out and get a loan from the bank, what happens?  A bunch of numbers appear in your account and then you go out and spend them.

Where did those numbers come from?  Nowhere.  The bank just made them up.  Legally.  They then make up a bunch of numbers somewhere else in their financial statement that show that they have a liability on their books.  They are allowed to have liabilities that exceed their deposits by many multiples. 

The only reason the bank really wants your deposits is just so they have sufficient cash on hand to justify creating a lot of money out of thin air and loaning it to people.  The government likes this as long as the banks are not overleveraged. 

The government further insures a number of residential mortgages (e.g., guarantees to pay them if the homeowner doesn't) so that the banks can more easily sell them to investors and get them off their books so they can create more mortgages.  The government also lets a lot of people write off a portion of the interest on their taxes (though this is now reduced).  All part of a bigger plan to get you to buy a house and work really hard to pay it off.  (Not a knock, I own a house and work, it is what it is.) 

(The government also wants you to have kids but that's a story for another day.) 

[LWYRUP]

I've read a lot of post here and on reddit about how it's always mathematically better to invest in the market than pay off a <4-5% mortgage. If that's the case why don't banks invest all of their capital in the market? What makes them lend money at a mathematical disadvantage?

I think that's a great question. It makes sense in a place like Canada where most mortgage rates are usually fixed for short periods of time (~ 5 years) and the premium to get longer is usually large. When I lived in Canada, I think that the longest we could fix a rate for was ~ 10 years. Payments were were still calculated using 25 year amortizations, but when your term ended you'd need to get a new mortgage at whatever the current rates were.

I don't understand why American banks are willing to take the risk on a 30 year fixed mortgages (or at least why the premium to lock your rate in for that long isn't higher). They do seem to charge a mortgage origination fee which didn't exist when we were in Canada. This would have been the case for us if we didn't buy our house in cash...but I don't know if we were just kind of getting screwed since we didn't have any US credit history (i.e. high mortgage origination fee and high rate from the few places that would even offer us a mortgage).

My guess is that US banks (1) like having the steady inflows of cash over long periods of time and (2) rates have been falling for 40 years so long term mortgages have made sense over that time frame.

Were 30 year mortgages still available in the US from the 1960s - 1980s when rates were generally increasing?

30 year mortgages in the US are typically insured by semi-private insurance agencies (Fannie Mae and Freddie Mac).  They are semi-private because they make money when things go up and then get bailed out when things go bad, which is really the best of both worlds.  (I actually have job applications into one of them -- if you can't beat them, join them I guess.) 

Banks wouldn't do them, or at least not en masse or for the same pricing, if they couldn't get the insurance and then package them into mortgage bonds and sell them off. 

Prior to this system being set up people would typically get 5 year "balloon" mortgages.  A balloon mortgage is when a big lump sum of principal comes due right at the end.  A lot of commercial real estate investors still take out these types of mortgages, and then they refinance them right at the end.  Not for the faint of heart, and it didn't work out in the Great Depression. 

"Well somebody told us Wall Street fell
But we were so poor that we couldn't tell
Cotton was short and the weeds were tall
But Mr. Roosevelt's a gonna save us all

Well momma got sick and daddy got down
The county got the farm and they moved to town
Pappa got a job with the TVA
He bought a washing machine and then a Chevrolet"

[Jrr85]

I've read a lot of post here and on reddit about how it's always mathematically better to invest in the market than pay off a <4-5% mortgage. If that's the case why don't banks invest all of their capital in the market? What makes them lend money at a mathematical disadvantage?

Lots of reasons, but for one thing when you borrow on a mortgage to invest in the stock market, you are borrowing on a fixed rate amortized over thirty years (if you're doing it right, at least).  When the bank borrows money, it is usually borrowing under terms where it has to return the money on demand (if you are talking about normal checking accounts) or on a relatively short time line between say 6 months and 6 years (if you are talking about certificates of deposits, for example).  The math doesn't work the same when you are dealing with shorter time periods because the volatility is too great. 

[Cranky]

Note that in difficult times, banks don’t finance a lot of mortgages (reference 2009.) Note that mortgages are a secured loan. Note that there are many fees associated with loans.  Note that mortgage interest rates are not always low.

[mm1970]

I've read a lot of post here and on reddit about how it's always mathematically better to invest in the market than pay off a <4-5% mortgage. If that's the case why don't banks invest all of their capital in the market? What makes them lend money at a mathematical disadvantage?

Because when a bank loans you money, it's not money they actually have. Every dollar the bank actually has is loaned out multiple times. Sometimes (stupidly) hundreds of times. This only works out because they have a "guaranteed" income from all the borrower payments. The financial crash in 2008 was because many big banks got very stupid and started loaning out each dollar hundreds of times creating a comically unstable house of cards and when only a very small percent of borrowers defaulted that house of cards fell hard.


For more info, start here:
https://en.wikipedia.org/wiki/Fractional-reserve_banking
https://en.wikipedia.org/wiki/Money_multiplier

I read a book that talked about this a few years ago and it blew.my.mind.

I had no idea that banks loan money they don't have.  It was mind opening!

[marty998]

When you go out and get a loan from the bank, what happens?  A bunch of numbers appear in your account and then you go out and spend them.

Where did those numbers come from?  Nowhere.  The bank just made them up.  Legally.  They then make up a bunch of numbers somewhere else in their financial statement that show that they have a liability on their books.  They are allowed to have liabilities that exceed their deposits by many multiples. 

Ok lets put some sense back into this thread because this is not strictly correct. Yes it comes out of thin air - this is the whole point of "credit", otherwise it would all be done with cash. Lending creates deposits. They don't make up a bunch of numbers somewhere else on their financial statements. They are actual liabilities, and if a bank cannot satisfy payment of its liabilities when every depositor wants their cash at the same time it fails. So this is where capital ratios and liquidity coverage ratios come in.

Consider this example (follow the maths):

Bank MMM starts business with $1m cash in notes and coins and therefore $1m equity.

Marty998 goes to his local bank (Bank MMM) to get a home loan.

Bank MMM says "sure marty998, we'll lend you $1m". Marty is advanced $1m.

Bank MMM has now has $2m assets ($1m notes and coins, $1m loan receivable) and a liability ($1m deposits), and still $1m in equity because marty998 hasn't withdrawn the funds yet and it's sitting in his account.

marty998 then buys 2 houses for $500k each. The seller of Property A banks with Bank LMN and the seller of Property B banks with Bank PQR. marty998 sends the funds via EFT to Bank LMN and Bank PQR.

Bank MMM doesn't actually settle the funds, instead it creates payables (POFI - payables to other financial institutions) to Bank LMN and Bank PQR and zeros out its deposit liability to marty998.

Bank MMM's balance sheet now looks like

$1m notes and coins
$1m loan receivable
($1m) due to other banks
($1m) equity

marty998 is then charged interest of $100k, and then he deposits his salary of $200k (paid by his employer who Banks with Bank ABC) and marty998 pays the interest on the loan

$1m notes and coins
$1.1m loans receivable
($1m) due to other banks
($1.1m) equity

_________________________

$1m notes and coins
$0.2m due from other banks
$1m loans receivable
($1m) due to other banks
($0.1m) deposits due to marty998
($1.1m) equity
_________________________

You can see how quickly Bank balance sheets start to get very complicated from a few simple transactions.

Now add in other customers. Some who bank with Bank MMM, some who bank with other Banks. If two customers of Bank MMM transact with each other, all Bank MMM has to do is debit the deposit account of one customer and credit the deposit account of the other (no impact to the bank).

In reality, a Bank with millions of customers is generally going to have quite a stable and relatively predictable balance sheet, with loans constantly being drawn and repaid (every house that is bought is also sold!)

The system works because not everyone wants to withdraw their deposits from ATMs and turn them to notes and coins at the same time. Predicting just how many people want their deposits in cash at any point in time is where Bankers earn their money.

(You can tell I love this shit).

[mustachepungoeshere]

When you go out and get a loan from the bank, what happens?  A bunch of numbers appear in your account and then you go out and spend them.

Where did those numbers come from?  Nowhere.  The bank just made them up.  Legally.  They then make up a bunch of numbers somewhere else in their financial statement that show that they have a liability on their books.  They are allowed to have liabilities that exceed their deposits by many multiples. 

Ok lets put some sense back into this thread because this is not strictly correct. Yes it comes out of thin air - this is the whole point of "credit", otherwise it would all be done with cash. Lending creates deposits. They don't make up a bunch of numbers somewhere else on their financial statements. They are actual liabilities, and if a bank cannot satisfy payment of its liabilities when every depositor wants their cash at the same time it fails. So this is where capital ratios and liquidity coverage ratios come in.

Consider this example (follow the maths):

Bank MMM starts business with $1m cash in notes and coins and therefore $1m equity.

Marty998 goes to his local bank (Bank MMM) to get a home loan.

Bank MMM says "sure marty998, we'll lend you $1m". Marty is advanced $1m.

Bank MMM has now has $2m assets ($1m notes and coins, $1m loan receivable) and a liability ($1m deposits), and still $1m in equity because marty998 hasn't withdrawn the funds yet and it's sitting in his account.

marty998 then buys 2 houses for $500k each. The seller of Property A banks with Bank LMN and the seller of Property B banks with Bank PQR. marty998 sends the funds via EFT to Bank LMN and Bank PQR.

Bank MMM doesn't actually settle the funds, instead it creates payables (POFI - payables to other financial institutions) to Bank LMN and Bank PQR and zeros out its deposit liability to marty998.

Bank MMM's balance sheet now looks like

$1m notes and coins
$1m loan receivable
($1m) due to other banks
($1m) equity

marty998 is then charged interest of $100k, and then he deposits his salary of $200k (paid by his employer who Banks with Bank ABC) and marty998 pays the interest on the loan

$1m notes and coins
$1.1m loans receivable
($1m) due to other banks
($1.1m) equity

_________________________

$1m notes and coins
$0.2m due from other banks
$1m loans receivable
($1m) due to other banks
($0.1m) deposits due to marty998
($1.1m) equity
_________________________

You can see how quickly Bank balance sheets start to get very complicated from a few simple transactions.

Now add in other customers. Some who bank with Bank MMM, some who bank with other Banks. If two customers of Bank MMM transact with each other, all Bank MMM has to do is debit the deposit account of one customer and credit the deposit account of the other (no impact to the bank).

In reality, a Bank with millions of customers is generally going to have quite a stable and relatively predictable balance sheet, with loans constantly being drawn and repaid (every house that is bought is also sold!)

The system works because not everyone wants to withdraw their deposits from ATMs and turn them to notes and coins at the same time. Predicting just how many people want their deposits in cash at any point in time is where Bankers earn their money.

(You can tell I love this shit).

This is amazing.

I know you love your job (most days), and you are brilliant at it, but you should teach financial literacy in (early) retirement.

[RedmondStash]

Mortgage interest rates are extremely low right now. I bought my house with a large first mortgage and a smaller second mortgage instead of private mortgage insurance, and I think the rates were 7.5% and 8.25%. They've been even higher in the past.

Remember that the financial landscape of the last 10 years or so is very different from the previous 10, or the 10 before that. I'm still amazed that there are mortgages out there for less than 7%.

[BTDretire]

Mortgage interest rates are extremely low right now. I bought my house with a large first mortgage and a smaller second mortgage instead of private mortgage insurance, and I think the rates were 7.5% and 8.25%. They've been even higher in the past.

Remember that the financial landscape of the last 10 years or so is very different from the previous 10, or the 10 before that. I'm still amazed that there are mortgages out there for less than 7%.

 Ya, much higher, when I was shopping for my first mortgage (1984) a 30 year mortgage was 16-3/4%.
I ended up with a 13-3/4% three year balloon.

[Capt j-rod]

Pull into any small town in America... The three nicest buildings in town are the bank, the church, and the town hall... You don't want to trust any of these places with your money.

[Brother Esau]

Pull into any small town in America... The three nicest buildings in town are the bank, the church, and the town hall... You don't want to trust any of these places with your money.

HaHa! sadly true, but funny

[Dr. Pepper]

I think other people have answered this well, but the short answer is FDIC has limits on what member banks can do with their capital. If you want to be FDIC insured ( and most do, because it allows you to get demand and time deposits which are the cheapest source of capital), you have to maintain certain Teir 1 capital ratios (6% under Basel III). These are calculated by dividing the teir 1 capital by risk weighted assets. Equity assets carry a higher risk, and if you want to keep your ratio within the limits imposed by the FDIC, then you can't have 0 weighting to lower risk assets such as mortgages and 100% weight of higher risk stuff like equities. If you really want to dig into the weeds, this is a good source for how the risks to the capital is calculated. https://www.fdic.gov/regulations/safety/manual/section2-1.pdf

[marty998]

Pull into any small town in America... The three nicest buildings in town are the bank, the church, and the town hall... You don't want to trust any of these places with your money.

HaHa! sadly true, but funny

Very true, but if I may add (to ruin this quip), some of the old Post Office buildings are quite nice too.