week 6 Flashcards
CHARACTERISTICS OF THE RESIDENTIAL MORTGAGE
-Mortgage interest rates
-Loan terms
-Mortgage loan amortization
WHAT ARE MORTGAGES?
A mortgage is a type of loan specifically used to purchase real estate, such as a home or property. In a mortgage agreement, the borrower (homebuyer) receives a loan from a lender (usually a bank or financial institution) to finance the purchase of the property. In return, the borrower agrees to repay the loan over a specified period, typically with interest.
Mortgage interest rates and factors that affects it
Stated interest rate on a mortgage loan is influenced by several factors
Market rate: are the prevailing interest rates in the broader financial markets, the market rate is determined by demand and supply. The market rates are proportional to to the mortgage rate.
Term: the term refers to the length of time over which the borrower agrees to repay the loan. Longer-term mortgages generally have higher interest rates compared to shorter-term loans.
Discount points: are prepaid interest that borrowers can pay upfront at the time of loan closing in exchange for a reduced interest rate on their mortgage.
Loan terms
Mortgage loan contracts contain many legal terms that need to be understood. Most protect the lender from
financial loss.
Collateral: The property serves as security for the loan. Lender can sell it if the borrower defaults. (a lien against the property. A lien is a public record that attaches to the property, advising that the property is collateral and gives the lender the right to sell the property if the underlying loan defaults)
Down Payment: Upfront payment to reduce loan amount. Typically 20% of the property price.
PMI: an insurance policy that guarantees to make up any discrepancy between the value of the property and the loan amount, it is required for loans with <20% down payment,
Qualifications: Lenders check credit score, income, and debt levels. Aim for a good credit score and manageable debt.
Mortgage loan amortization
Mortgage loans are amortized loans. This means that a fixed, level
payment will pay interest due plus a portion of the principal each
month. It is designed so that the balance on the mortgage will be
zero when the last payment is made.
Types of mortgage loans
Insured and Conventional Mortgages
Fixed and Adjustable-rate mortgage
Insured and conventional mortgages
Insured Mortgages: These are backed by the FHA or VA, often requiring low or no down payment. Eligibility includes military service or low income, with a borrowing limit.
Conventional Mortgages: These are not guaranteed and often require private mortgage insurance by the lenders. Borrowers usually need higher down payments.
Fixed- and Adjustable-Rate Mortgages
Fixed-Rate Mortgages: the interest rate and the monthly payment do not vary of the life time of the
mortgage.
Adjustable-Rate Mortgages: is tied to some market interest rate and therefore changes over time. ARMs
usually have limits, called caps, on how high (or low) the interest rate can move in one year and during the term of the loan.
Secondary mortgage market
The secondary mortgage market is a financial market where existing mortgage loans are bought and sold. It allows lenders (like banks or mortgage brokers) to sell the mortgages they originate to other investors (to institutions like Fannie Mae), freeing up capital to make more loans.
Fannie Mae buys the mortgages loans using funds from the bonds sold. This enables lenders to offer more loans to the borrowers to stablizing housing market
Securitization of mortgages (several problems when trying to sell mortgages)
- Mortgages are usually too small to be wholesale instruments;
- Mortgages are not standardized. They have different times to maturity, interest rates and contract
terms. Which makes it difficult to bundle a large number of mortgages together. - Mortgages have unknown default risk.
Mortgage-backed security
An alternative to selling mortgages directly to investors is to create a new security backed by a large number of mortgages assembled into what is called a mortgage pool.
A trustee, such as a bank or a government agency holds the mortgage pool, which serves as collateral for the new security. This process is called securitization
subprime loans and CDOs
are those made to borrowers who do not qualify for loans at the usual market rate of interest because of a poor credit rating or because the loan is larger than justified by their income.
By pooling many loans into a single CDO, they created a diversified portfolio of assets. (it increases the subprime loans) The idea was that even though some of the loans in the pool might default (like subprime loans), the risk would be spread out across all of the loans, making the overall pool seem safer.
What factors have led to a subprime lending ?
- New mortgage products (2/28 ARMS, NINJA loans) made expensive houses “affordable”
- The creation of CDOs (i.e. bundles of MBSs) helped create deal flow to continue lending in subprime
markets - When house prices were increasing, subprime borrowers had an out if problems arose (i.e., they could sell their houses with a profit)
The real estate bubble (factors that cause it)
- The increase in subprime loans created new demand for housing
- Real estate speculators: everyone started noticing that quick and easy money was made by buying and selling real estate because of increasing housing prices. Which further increased the demand.
Securitized mortgage and its disadvantages
was initially hailed as a method for reducing the risk to lenders. But this led to increased moral hazard by separating the lender from the risk