Mortgages: A Comprehensive Guide by Dr. Lakshmi Kalyanaraman

The Mortgage Markets Chapter 14 Dr. Lakshmi Kalyanaraman 1

What are mortgages? Long-term loan secured by real estate. Loan to finance construction of an office building or purchase of a home Dr. Lakshmi Kalyanaraman 2

Amortized mortgage Borrower pays off the loan over time in some combination of principal and interest payments that result in full payment of the debt by maturity. Dr. Lakshmi Kalyanaraman 3

Balloon mortgage Only interest is paid over the life of the mortgage Principal is paid at maturity High default risk Dr. Lakshmi Kalyanaraman 4

CHARACTERISTICS OF RESIDENTIAL MORTGAGES Dr. Lakshmi Kalyanaraman 5

Mortgage interest rates Determined by three factors: 1. current long-term market rates 2. life of the mortgage 3. number of discount points paid Dr. Lakshmi Kalyanaraman 6

Market rates Determined by the supply of and demand for long-term funds Determined by a number of global, national and regional factors Dr. Lakshmi Kalyanaraman 7

Term Usually the lifetime is 15 or 30 years Lenders also offer 20 years Longer-term mortgages have higher interest rate than mortgages shorter-term Interest rate risk falls as the term to maturity decreases Dr. Lakshmi Kalyanaraman 8

Discount points Interest payments made at the beginning of a loan A loan with one discount point means that the borrower pays 1% of the loan amount at closing Closing is when the borrower signs the loan paper and receives the proceeds of the loan Dr. Lakshmi Kalyanaraman 9

Discount points Lender reduces the interest rate on the loan Dr. Lakshmi Kalyanaraman 10

Discount points Borrower evaluates Reduced interest rate over the life of the loan Versus Increased up-front expense Dr. Lakshmi Kalyanaraman 11

Discount points Depends on how long the borrower will hold on to the loan May not be feasible if borrower repays in 5 years or less Dr. Lakshmi Kalyanaraman 12

LOAN TERMS Dr. Lakshmi Kalyanaraman 13

Collateral Real estate bought with the mortgage loan is pledged as collateral Lending institution will place a lien against the property till the loan is repaid Lien is a public record that attaches to the title of the property Dr. Lakshmi Kalyanaraman 14

Collateral Lender gets the right to sell the property if the underlying loan defaults No one can buy the property and obtain clear title to it without paying off this lien Existence of liens against real estate explains why title search is important part of mortgage loan Dr. Lakshmi Kalyanaraman 15

Down payment Borrower pays a portion of purchase price Balance of purchase price is paid by the loan proceeds Down payment reduces default risk Dr. Lakshmi Kalyanaraman 16

Private mortgage insurance Insurance contract purchased by FI paid by the borrower guaranteeing to pay the FI Difference between the value of the property and the balance remaining in the mortgage, in case of default Dr. Lakshmi Kalyanaraman 17

Mortgage loan amortization Borrower agrees to pay a monthly amount of principal and interest that will fully amortize the loan by its maturity Fully amortize means that the payments will pay off the outstanding indebtedness by the time the loan matures During early years of the loan, the lender applies most of payment to interest and small amount to outstanding principal balance Dr. Lakshmi Kalyanaraman 18

TYPES OF MORTGAGE LOANS Dr. Lakshmi Kalyanaraman 19

Insured and conventional mortgages Dr. Lakshmi Kalyanaraman 20

Insured mortgages Originated by banks or other mortgage lenders but are guaranteed by government agencies Applicants either served in the military or having income below a given level Dr. Lakshmi Kalyanaraman 21

Insured mortgages Can borrow only up to a certain amount Very low or zero down payment Agency guarantees the payment of mortgage loan if the borrower defaults Dr. Lakshmi Kalyanaraman 22

Conventional mortgages Not guaranteed Most lenders require that borrowers to obtain private mortgage insurance on all loans with loan-to-value exceeding 80% Dr. Lakshmi Kalyanaraman 23

FIXED AND ADJUSTABLE-RATE MORTGAGES Dr. Lakshmi Kalyanaraman 24

Fixed rate mortgages Interest rate and the monthly payment do not vary over the life of the mortgage Dr. Lakshmi Kalyanaraman 25

Adjusted-rate mortgages Tied to some market interest rate Changes over time ARMs usually have limits Caps, how high the interest rate can move in one year and during the term of the loan For example 2% in one year and 6% over the life of the loan Dr. Lakshmi Kalyanaraman 26

Fixed versus ARM Borrowers prefer fixed as ARMs may cause financial hardship if interest rate rises However, fixed rate borrowers lose if interest rate falls Borrowers are risk-averse means that fear of hardship most often overwhelms anticipation of savings Dr. Lakshmi Kalyanaraman 27

Fixed versus ARM Lenders, by contrast, prefer ARMs because ARMs lessen interest-rate risk Interest-rate risk is the risk that rising interest rates will cause the value of debt instruments to fall. The effect on the value of the debt is greatest when the debt has a long term to maturity. Dr. Lakshmi Kalyanaraman 28

Fixed versus ARM Since mortgages are usually long-term, their value is very sensitive to interest-rate movements Lending institutions can reduce the sensitivity of their portfolios by making ARMs instead of standard fixed-rate loans. Dr. Lakshmi Kalyanaraman 29

Fixed versus ARM Seeing that lenders prefer ARMs and borrowers prefer fixed-rate mortgages Lenders must entice borrowers by offering lower initial interest rates on ARMs than on fixed-rate loans Dr. Lakshmi Kalyanaraman 30

OTHER TYPES OF MORTGAGES Dr. Lakshmi Kalyanaraman 31

Graduated payment mortgages Useful for home buyers who expect their incomes to rise Has lower payments in the first few years, may not even cover interest Then payments rise Advantage is borrowers qualify a higher loan than conventional mortgage Buyers can buy adequate house now Payments escalate later when income does or not Dr. Lakshmi Kalyanaraman 32

Growing equity mortgages Growing equity mortgage helps to pay off loan in short period Initial payments like conventional mortgage Over time payment increases to reduce principal quickly No prepayment penalty Dr. Lakshmi Kalyanaraman 33

Graduated versus growing Difference between graduated payment and growing equity mortgages is that the graduated is to qualify for a higher loan by reducing the initial payments and loan paid in 30 years. But growing is to help prepayment Dr. Lakshmi Kalyanaraman 34

Second mortgages (piggyback) On same real estate like first mortgage Second mortgage junior to the original loan In case of default, the original loan will be paid off first and the second mortgage holder from the left over funds Dr. Lakshmi Kalyanaraman 35

Second mortgages (piggyback) Borrowers use the equity they have in their homes as security for another loan Dr. Lakshmi Kalyanaraman 36

Second mortgages (piggyback) An alternative to the second mortgage would be to refinance the home at a higher loan amount than is currently owed. The cost of obtaining a second mortgage is often much lower than refinancing. Dr. Lakshmi Kalyanaraman 37

Reverse annuity mortgages Innovative method for retired people to live on the equity they have in their homes The contract for a RAM has the bank advancing funds on a monthly schedule. This increasing-balance loan is secured by the real estate borrower does not make any payments against the loan. When the borrower dies, the borrower s estate sells the property to retire the debt. Dr. Lakshmi Kalyanaraman 38

Reverse annuity mortgages The advantage of the RAM is that it allows retired people to use the equity in their homes without the necessity of selling it. For retirees in need of supplemental funds to meet living expenses, the RAM can be a desirable option. Dr. Lakshmi Kalyanaraman 39

Mortgage institutions Many institutions making mortgage loans do not want to hold long-term Short-term sources used for long-term loans Many lenders sell the loans immediately to another investor Borrower may not be aware Originator frees the funds and gets loan origination fees normally 1%

Loan servicing Some originators provide loan servicing Collect payments from borrowers, passes principal and interest to the investor, keeps record and reserve account for payment of insurance and taxes Earn a fee of around 0.5% of loan amount every year for servicing

Loan servicing 1. Originator packages the loan for an investor. 2. Investor holds the loan. 3. Servicing agent handles the paperwork. Dr. Lakshmi Kalyanaraman 42

Secondary mortgage market Problems in selling mortgages: 1. Mortgages are too small to be wholesale instruments. Mortgages value around $250,000 while commercial paper is around $5 million Dr. Lakshmi Kalyanaraman 43

Secondary mortgage market Second problem with selling mortgages in the secondary market was that they were not standardized. They have different times to maturity, interest rates, and contract terms. That makes it difficult to bundle a large number of mortgages together Dr. Lakshmi Kalyanaraman 44

Secondary mortgage market Third, mortgage loans are relatively costly to service The lender must collect monthly payments, often pay property taxes and insurance premiums, and service reserve accounts. Finally, mortgages have unknown default risk These problems inspired the creation of the mortgage-backed security, also known as a securitized mortgage Dr. Lakshmi Kalyanaraman 45

Securitization Process of taking an illiquid asset, or group of assets and through financial engineering transforming them into a security Dr. Lakshmi Kalyanaraman 46

Mortgage backed security Large number of mortgages are pooled into mortgage pool A trustee, a bank or government agency, holds mortgage pool as collateral for new security This process is called securitization 47

Major types of MBS Pass-through security Collateralized Mortgage Obligations (CMO) Mortgage Backed Bond 48

Pass-through Mortgage Securities FIs pool mortgages and offer interest in the pool in the form of pass-through certificates Each pass through security represents fractional ownership in mortgage pool Pass through promised payments of principal and interest on pools of mortgages to secondary market investors No guaranteed annual coupon Originating FI or third party servicer takes a fee 49

Collateralized Mortgage Obligations (CMO) Multiclass pass-through with multiple bond holder classes or tranches Pass through a pro-rata of mortgage pool but CMO multi-class pass-through with a number of different bond holder classes or tranches Pass-through no guaranteed coupon, but CMO, each class has a different guaranteed coupon Mortgage prepayments retire only one tranche at a time, so all other trances are sequentially prepayment protected 50