Loan Servicing Explained: What It Is & How It Works

Loan servicing is the way a finance company (a lender) goes about collecting principal, interest, and escrow payments that are due or overdue. The practice deals with all types of loans; however, mortgagesMortgageA mortgage is a loan – provided by a mortgage lender or a bank – that enables an individual to purchase a home. While it’s possible to take out loans to cover the entire cost of a home, it’s more common to secure a loan for about 80% of the home’s value. are the most common.

Mortgages are frequently backed by the government or an affiliated agency (a government-sponsored entity or GSE). A private lender or GSE won’t usually service loans they purchase. The responsibility generally falls onto the bank that originated the mortgage to do it, although the bank may outsource the servicing as well.

Summary

• Loan servicing is the process of collecting payments on a loan and passing along distributions to the parties involved.
• The servicer collections a portion of each payment as payment for servicing the loan.
• Banks were traditionally responsible for creating and servicing loans until changes in the industry made it less profitable to engage in the business. 

Where Service Payments Go

The person or company responsible for servicing a loan – the servicer – distributes payments to a variety of different parties that may be attached to the loan:

• Principal/interest payments go to the mortgage holder or to investors that hold mortgage-backed securities (MBS)Mortgage-Backed Security (MBS)A Mortgage-backed Security (MBS) is a debt security that is collateralized by a mortgage or a collection of mortgages. An MBS is an asset-backed security that is traded on the secondary market, and that enables investors to profit from the mortgage business
• Mortgage trustees and guarantors get remitting fees
• Insurance and taxes on escrowed funds must be paid

Other potential areas where payments may go (depending on the loan, its terms, and the investors involved) include foreclosure executors, delinquency monitors, and loan/term restructuring centers.

The servicer gets fees for the duties performed in servicing the loan, including making sure that payments are disbursed to the correct parties in a timely way. Failure to make payments or making late payments on a loan usually results in a late fee that the servicer collects. (During the housing market boom and the subsequent crash, less-than-reputable servicers targeted individuals who were likely to be late on payments, so as to collect additional late fees).

The Business of Servicing Loans

Loan servicing is now considered a business unto itself. Once a fundamental part of the banking industry, after securitizationSecuritizationSecuritization is a risk management tool used to reduce the idiosyncratic risk associated with the default of individual assets. changed the face of finance in general, servicing overdue loans grew less profitable for banks. Today, most banks create new loans and then pass off the servicing duties to a different financial institution or a company that specializes in servicing such loans.

Compensation

The compensation for servicing loans is similar to interest. The servicer takes a minimal percentage of the regular loan payments that the borrower pays. They typically take anywhere from 0.25% to 0.50% of each payment.

More Resources

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• Debt CovenantDebt CovenantsDebt covenants are restrictions that lenders (creditors, debt holders, investors) put on lending agreements to limit the actions of the borrower (debtor).
• Financial IntermediaryFinancial IntermediaryA financial intermediary refers to an institution that acts as a middleman between two parties in order to facilitate a financial transaction. The institutions that are commonly referred to as financial intermediaries include commercial banks, investment banks, mutual funds, and pension funds.
• Principal PaymentPrincipal PaymentA principal payment is a payment toward the original amount of a loan that is owed. In other words, a principal payment is a payment made on a loan that reduces the remaining loan amount due, rather than applying to the payment of interest charged on the loan.
• Retainer FeeRetainer FeeA retainer fee is an upfront cost paid by an individual for the services of an advisor, consultant, lawyer, freelancer, or other professional.