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CH 3mortgage Market

The mortgage market facilitates property financing through secured debt, allowing households and corporations to purchase homes and commercial properties. Various types of residential mortgages exist, including fixed-rate, adjustable-rate, graduated-payment, growing-equity, second mortgages, and shared-appreciation mortgages, each with unique characteristics. Investors in mortgage loans face risks such as credit risk, liquidity risk, price risk, and prepayment risk.

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8 views14 pages

CH 3mortgage Market

The mortgage market facilitates property financing through secured debt, allowing households and corporations to purchase homes and commercial properties. Various types of residential mortgages exist, including fixed-rate, adjustable-rate, graduated-payment, growing-equity, second mortgages, and shared-appreciation mortgages, each with unique characteristics. Investors in mortgage loans face risks such as credit risk, liquidity risk, price risk, and prepayment risk.

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ummenaifa34
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CHAPTER

MORTGAGE MARKET

[Book: Financial Institutions and Markets;


Jeff Madura ]
Background of Mortgage Market:

A mortgage is a form of debt created to finance


investment in property. The debt is secured by the
property, so if the property owner does not meet
payment obligations, the creditor can seize the
property. Financial institutions such as saving
institutions and mortgage companies serve as
intermediaries by originating mortgage.
Background of Mortgage Market
(cont..)
The mortgage contract specifies the mortgage rate,
the maturity, and the collateral that is backing the
loan. Overall, mortgage market allow household
and corporations to increase their purchases of
homes, condominiums, and commercial property
and thereby finance economic growth.
Types of Residential Mortgage:

Various types of residential mortgage are available


to homeowners, including the following:
• Fixed-rate mortgages
• Adjustable-rate mortgages
• Graduated-payment mortgages
• Growing-equity mortgages
• Second mortgages
• Shared-appreciation mortgages
Types of Residential Mortgage:
1. Fixed-rate mortgages: A fixed-rate mortgage
locks in the borrower’s interest rate over the life of
the mortgage. Thus, the periodic interest payment
received by the lending financial institution is
constant.
If interest rates increase over time, the financial
institution’s cost of obtaining funds will increase
(vise versa)
 Borrowers with fixed-rate mortgage do not
suffer from the effects of rising interest rates, but
they also fail to benefit from declining rates.
Types of Residential Mortgage:

2. Adjustable-rate Mortgages (ARM):


An adjustable-rate mortgages allows the mortgage
interest rate to adjust to market conditions. A
common ARM uses a one-year adjustment, with
the interest rate tied to the average Treasury bill
rate over the previous year, the average T-bill rate
plus 2 percent may be specified.
The fixed rate is typically higher than the
adjustable rate at any given point in time when a
mortgage is originated.
Types of Residential Mortgage:
3. Graduated-Payment Mortgages (GPM): A
graduated-payment mortgage allows the borrower
to initially make small payments on the mortgage;
the payments increase on a graduated basis over the
first 5 to 10 years and then level off.
4. Growing-Equity Mortgages: A growing-equity
mortgage is similar to a GPM in that the monthly
payments are initially low and increase over time.
Unlike the GPM, however, the payments never
level off but continue to increase throughout the
life of the loan.
Types of Residential Mortgage:
5. Second Mortgages: A second mortgage can be used
in conjunction with the primary or first mortgage.
Some financial institutions may limit the amount of
the first mortgage based on the borrower’s income.
Other financial institutions may then offer a second
mortgage, with a maturity shorter than on the first
mortgage. In addition, the interest rate on the second
mortgage is higher because its priority claim against
the property in the event of default is behind that of
the first mortgage. The higher interest rate reflects
greater compensation as a result of the higher risk
incurred by the provider of the second mortgage.
Types of Residential Mortgage:

6. Shared-Appreciation Mortgages:
A shared-appreciation mortgage allows a home
purchaser to obtain a mortgage at a below-market
interest rate.
Investment Risks

The principal investors in mortgage loans


include thrifts and commercial banks.
Pension funds and life insurance companies
also invest in these loans, but their ownership
is small compared to that of the banks and
thrifts.
Investment Risks
Investors face four main risks by investing in
mortgage loans:
1. Credit risk

2. Liquidity risk

3. Price risk and

4. Prepayment risk
Investment Risks
Credit Risk:
Credit risk is the risk that the homeowner/borrower
will default which is the possibility that borrowers
will make late payments or even default.
Liquidity Risk:
Mortgage loans tend to be rather illiquid because
they are large and indivisible. Although there is a
secondary market for mortgage loan, the fact is that
bid-ask spreads are large compared to other debt
instruments.
Investment Risks
Price Risk:
The price of a fixed-income instrument will
move in an opposite direction from market
interest rates. Thus, a rise in interest rates will
decrease the price of a mortgage loan.
Prepayment Risk:
Prepayment risk is the risk that a borrower may
prepay the mortgage in response to a decline in
interest rates.

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