What is Loan Servicing

Loan servicing refers to the administrative aspects of a loan from the time the proceeds are dispersed until the loan is paid off. Loan servicing includes sending monthly payment statements and collecting monthly payments, maintaining records of payments and balances, collecting and paying taxes and insurance (and managing escrow and impound funds), remitting funds to the note holder and following up on delinquencies. Loan servicing as a function can be carried out by the bank or financial institution that issued the loans, a non-bank entity specializing in loan servicing, or a subservicer that operates as a third-party vendor for the lending institution.

BREAKING DOWN Loan Servicing

Loan servicing was traditionally seen as a core function held within banks. Banks issued the original loan, so it made sense that they would be responsible for handling the administration of the loan. That was, of course, before widespread securitization changed the nature of banking and finance in general. Once loans — and mortgages in particular — were repackaged into securities and sold off a bank’s books, the servicing of the loans proved to be a less profitable business line than the origination of new loans. So the loan servicing part of the loan life cycle was separated away from origination and opened up to the market.

Loan Servicing as a Business

Loan servicing is now an industry in and of itself. Loan servicers are compensated by retaining a relatively small percentage of each periodic loan payment, known as the servicing fee or servicing strip. This is usually 0.25% to 0.5% of the periodic interest payment. For example, if the outstanding balance on a mortgage is $100,000 and the servicing fee is 0.25%, the servicer is entitled to retain ((.0025 / 12) x 100,000) = $20 of the next periodic payment before passing the remaining amount to the note holder.

Loan servicing trades in the secondary market much like mortgage-backed securities (MBS). The valuation of mortgage servicing is similar to the valuation of MBS interest only strips. Servicing strips are subject to a great deal of prepayment risk and tend to show negative convexity.

Loan Servicing after the Mortgage Meltdown

Mortgages are the bulk of the loan servicing market. The mortgage meltdown brought increased scrutiny on the practice of securitization and the transfer of loan servicing obligations. As a result, the cost of loan servicing has increased compared to the pre-crisis levels, and there is always the potential for more regulation. Loan servicers have embraced technology to try and reduce compliance costs. There has also been a refocus by some banks on servicing their own loan portfolio to keep the connection with their retail clients.