The Debt Markets (part E)
by
Charles Lamson
The Anatomy of Mortgages
A mortgage is a long-term debt instrument for which real estate is used as collateral to secure the loan in the event of a default by the borrower. If the borrower defaults, the property is usually sold to recoup some or all of the losses. Mortgages are assets to the holder (lender) and liabilities to the issuer (borrower) who signs the mortgage agreement. They are similar to bonds, with the caveat that the underlying real property or land serves as collateral.
 |
Mortgages result from loans made to individuals or businesses to purchase land. Single- or multiple-family residential housing, commercial properties, or farms. Mortgages may also be made to finance new commercial or residential construction. The building (structure) or land serves as collateral. The bulk of mortgages are made to individuals to purchase residential property. Thus, households are the major borrowers in this market. In general, borrowers put down a minimum of 5 to 20 percent to purchase a property and take out a mortgage loan for the balance of the purchase price.
Mortgages have either a fixed or variable interest rate. With fixed-rate mortgages, the interest rate does not very over the life of the loan. Lenders are exposed to an interest rate risk---the risk that nominal interest rates will rise, causing the value of fixed-rate mortgages to decline. In addition, if long-term fixed-rates are funded with short-term deposits, the lending institution can experience a negative cash flow if the costs of liabilities rise above the earnings on assets. With variable-rate mortgages. the interest rate is adjusted as other market interest rates change. If rates move up, the interest rate on the mortgages increases, and vice versa. Thus, variable-rate mortgages reduce the interest rate risk of holding long-term mortgages because in the event that interest rates rise, loan payments and interest rates on the mortgages also rise.
An additional risk---the prepayment risk---is that mortgages will be prepaid early and that the funds will have to be reinvested at a lower return. This risk increases greatly when interest rates fall, particularly if they stay low for a significant period of time as borrowers refinance their mortgages to take advantage of the lower rates. This risk is much less for variable-rate loans than for fixed-rate loans because the interest rate on variable-rate loans will fall along with other rates.
Unlike a bond whereby the principal is repaid at maturity, the repayment of the principal on a mortgage is generally spread out over the life of the loan. Each month, a constant monthly payment is made that includes some part of the principal in addition to the interest payment. At the end of the loan, the mortgage has been fully repaid. This is known as amortization. Mortgages are usually made for up to 30 years, although in recent years, shorter-term mortgages have increased because they result in tremendous interest savings over the life of the loan.
Residential mortgages may also be insured by an agency of the federal government. The insurance guarantees the repayment of the principal and interest in the event that the borrower defaults. This eliminates the credit or default risk for the lender. The two federal agencies that guarantee mortgages are the Federal Housing Administration (FHA) and the Veterans Administration (VA). For a .5 fee, the FHA insures mortgage loans made by privately owned financial institutions up to a certain amount that varies by state depending on average housing costs. The loan limit is adjusted each year in response to changes in housing prices. Borrowers must meet certain conditions dealing with income and credit as defined by the FHA. FHA loans are designed to help low-income families purchase homes. With the government guarantee, the lender does not have to worry about the borrower defaulting. VA loans are similar to FHA loans, but are designed to insure the principal and interest payments on loans made to veterans. The purpose is to help those who have served the country in the military to purchase homes. FHA and VA loans generally have small or no down payments.
Conventional mortgages have no federal insurance and are made by financial institutions and mortgage brokers. Conventional loans generally require a 5 to 20 percent down payment. Conventional mortgages may or may not require the borrower to purchase private insurance that would make the principal and interest payments in the event the borrower defaults. The borrower pays a higher interest rate to cover the cost of the insurance. Generally, when the down payment or equity in the property is less than 20 percent, lenders require borrowers to obtain private mortgage insurance. Private mortgage insurance is purchased from a privately owned insurance company.
Mortgage rates, the size of mortgage you can afford, and a payment calculator are available on the internet at www.mortgagequotes.lycos.com.
Another site with similar information is www.mtgprofessor.com.
Recap
Mortgages are long-term debt instruments used to purchase residential, commercial, and farm properties. The underlying property serves as collateral. Fixed-rate mortgages carry the risk to the lender that nominal interest rates will rise and the value of the mortgages will fall. When the interest rate falls borrowers will refinance at the lower rate, causing the lender to have to reinvest the funds at a lower rate. The interest rate on variable rate mortgages is adjusted as market rates change. The principal of a mortgage is generally amortized over the life of the loan. The principal and interest payments may be insured by the FHA or VA, which are agencies of the federal government. Conventional loans have no federal insurance and are made by financial institutions and mortgage brokers. Lenders may require borrowers with conventional loans to obtain private mortgage insurance.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 414-416*
END
|
No comments:
Post a Comment