What Is Loan Servicing, Loan Servicing Definition

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The administrative aspects of a loan are referred to as its "servicing," and they begin when the proceeds of the loan are distributed to the borrower and continue until the loan is paid back in full. Sending out monthly payment statements, collecting monthly payments, keeping records of payments and balances, collecting and paying taxes and insurance (and managing escrow funds), remitting funds to the note holder, and following up on any delinquencies are all part of the loan servicing process.

What Is Loan Servicing, Loan Servicing Definition

• Loan servicing is a function that can be carried out by the bank or financial institution that issued the loan or a third-party vendor, or to a company that specializes in loan servicing. In some cases, the bank or financial institution that issued the loan may also perform loan servicing.

• Loan servicing functions include collecting monthly payments, paying taxes, as well as other aspects of the loan that occur from the time the proceeds are dispersed till the loan is paid off.

• Loan servicing is now an industry in and of itself, and companies that provide this service are compensated by receiving a small percentage of loan payments.

How Loan Servicing Works

The lending institution may contract with the bank or other financial institution that issued the loans, an organization that is not a bank but specializes in loan servicing, or a third-party vendor to perform loan servicing on its behalf. Loan servicing may also refer to the obligation of the borrower to make timely payments of interest and principal on a loan as a way to maintain creditworthiness with lenders and credit-rating agencies. This obligation is meant to keep the borrower in good standing with the finance lending institution.

The servicing of loans was traditionally considered a core function that banks were responsible for. Because banks were the ones who initially granted the loan, it only made sense for them to be the ones who were responsible for managing the administration of the loan. That was, of course, before the widespread securitization of loans, which fundamentally altered the character of banking and finance in general. After loans, and mortgages in particular, were repackaged into securities and sold off of a bank's books, it was found that the servicing of existing loans was a less profitable business line than the initiation of brand new loans. Mortgages were the loans that were repackaged the most.

As a result, the part of the loan life cycle known as servicing was separated from origination and made available to market participants. The industry has become especially reliant on technology and software as a result of the burdensome record-keeping requirements associated with loan servicing, as well as the shifting behaviors and expectations of borrowers.

Loan Servicing Example

The servicing of loans has evolved into its own separate industry in recent years. Loan servicers receive compensation in the form of what is known as the servicing fee or the servicing strip, which is retained as a relatively small percentage of the outstanding balance. This fee is typically between 0.25 and 0.5 percentage points of the total amount due for each periodic payment on the loan.

If the monthly mortgage payments are $2,000 and the servicing fee is 0.25%, for instance, the servicer has the right to keep $5, or (0.0025 x 2,000), of each payment before sending the remaining amount to the holder of the note. This is because the servicing fee is calculated as follows:

Special Considerations

The majority of the loan servicing market is comprised of mortgages, which total to trillions of dollar’s worth of home loans; however, student loan servicing is also a very profitable business sector. As of the year 2018, only three companies were accountable for the collection of payments from approximately 30 million borrowers on 93% of the outstanding amount of government-owned student loans, which totaled $950 billion.

In the meantime, the most significant mortgage loan servicers are following a pattern that sees them gradually withdrawing from the market as a response to the growing regulatory concerns. Smaller, regional banks as well as non-bank servicers are moving into the space previously occupied by these larger banks.

Lenders, or large banks, have been in charge of loan servicing for the majority of its history; however, smaller, regional players and non-bank service providers are increasingly entering the market.

As a result of the subprime mortgage crisis that occurred during the financial crisis of 2007-2008, the practice of securitization as well as the transfer of loan servicing obligations came under increased scrutiny. As a direct consequence of this, the cost of loan servicing is currently higher than it was prior to the financial crisis, and there is always the possibility that additional regulation will be implemented.

In the meantime, some loan servicers have turned to technology in an effort to cut the costs associated with regulatory compliance costs. Additionally, some banks have refocused their attention on servicing their own loan portfolios in order to maintain a connection with their retail customers.

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