Saturday, July 14, 2007

Mortgage loan

Mortgage is the generic term for a loan secured by a real property. As with other types of loans, mortgages have an interest rate and are scheduled to amortize over a set period of time; typically 30 years. All types of real property can, and usually are, secured with a mortgage and bear an interest rate that is supposed to reflect the lender's risk.
Mortgage lending is the primary mechanism used in many countries to finance private ownership of residential property. For commercial mortgages see the separate article. Although the terminology and precise forms will differ from country to country, the basic components tend to be similar:

  • Property: the physical residence being financed. The exact form of ownership will vary from country to country, and may restrict the types of lending that are possible.
  • Mortgage: the security created on the property by the lender, which will usually include certain restrictions on the use or disposal of the property (such as paying any outstanding debt before selling the property).
  • Borrower: the person borrowing who either has or is creating an ownership interest in the property.
  • Lender: any lender, but usually a bank or other financial institution.
  • Principal: the original size of the loan, which may or may not include certain other costs; as any principal is repaid, the principal will go down in size.
  • Interest: a financial charge for use of the lender's money.
  • Foreclosure or repossession: the possibility that the lender has to foreclose, repossess or seize the property under certain circumstances is essential to a mortgage loan; without this aspect, the loan is arguably no different from any other type of loan.

Many other specific characteristics are common to many markets, but the above are the essential features. Governments usually regulate many aspects of mortgage lending, either directly (through legal requirements, for example) or indirectly (through regulation of the participants or the financial markets, such as the banking industry), and often through state intervention (direct lending by the government, by state-owned banks, or sponsorship of various entities). Other aspects that define a specific mortgage market may be regional, historical, or driven by specific characteristics of the legal or financial system.

Mortgage loan basics

Mortgage loans are generally structured as long-term loans, the periodic payments for which are similar to an annuity and calculated according to the time value of money formulae. The most basic arrangement would require a fixed monthly payment over a period of ten to thirty years, depending on local conditions. Over this period the principal component of the loan (the original loan) would be slowly paid down through amortization. In practice, many variants are possible and common worldwide and within each country.

Lenders provide funds against property to earn interest income, and generally borrow these funds themselves (for example, by taking deposits or issuing bonds). The price at which the lenders borrow money therefore affects the cost of borrowing. Lenders may also, in many countries, sell the mortgage loan to other parties who are interested in receiving the stream of cash payments from the borrower, often in the form of a security (by means of a securitization). In the United States, the largest firms securitizing loans are Fannie Mae and Freddie Mac, which are government sponsored enterprises.

Mortgage lending will also take into account the (perceived) riskiness of the mortgage loan, that is, the likelihood that the funds will be repaid (usually considered a function of the creditworthiness of the borrower); that if they are not repaid, the lender will be able to foreclose and recoup some or all of its original capital; and the financial, interest rate risk and time delays that may be involved in certain circumstances.

More recently, mortgage loan brokers have expanded their businesses to include a web presence. There is now even a market for standard web templates which are used by brokers who want to quickly develop an online component to their business.

Mortgage loan types

There are many types of mortgages used worldwide, but several factors broadly define the characteristics of the mortgage. All of these may be subject to local regulation and legal requirements.

  • Interest: interest may be fixed for the life of the loan or variable, and change at certain pre-defined periods; the interest rate can also, of course, be higher or lower.
  • Term: mortgage loans generally have a maximum term, that is, the number of years after which an amortizing loan will be repaid. Some mortgage loans may have no amortization, or require full repayment of any remaining balance at a certain date, or even negative amortization.
  • Payment amount and frequency: the amount paid per period and the frequency of payments; in some cases, the amount paid per period may change or the borrower may have the option to increase or decrease the amount paid.
  • Prepayment: some types of mortgages may limit or restrict prepayment of all or a portion of the loan, or require payment of a penalty to the lender for prepayment.
The two basic types of amortized loans are the fixed rate mortgage (FRM) and adjustable rate mortgage (ARM) (also known as a or variable rate mortgage). In many countries, floating rate mortgages are the norm and will simply be referred to as mortgages; in the United States, fixed rate mortgages are typically considered "standard." Combinations of fixed and floating rate are also common, whereby a mortgage loan will have a fixed rate for some period, and vary after the end of that period.

In a fixed rate mortgage, the interest rate, and hence periodic payment, remains fixed for the life (or term) of the loan. In the U.S., the term is usually up to 30 years (15 and 30 being the most common), although longer terms may be offered in certain circumstances. For a fixed rate mortgage, payments for principal and interest should not change over the life of the loan, although ancillary costs (such as property taxes and insurance) can and do change.

Adjustable Rate Mortgage(ARM)

Adjustable rates transfer part of the interest rate risk from the lender to the borrower, and thus are widely used where fixed rate funding is difficult to obtain or prohibitively expensive. Since the risk is transferred to the borrower, the initial interest rate may be from 0.5% to 2% lower than the average 30-year fixed rate; the size of the price differential will be related to debt market conditions, including the yield curve.

Additionally, lenders in many markets rely on credit reports and credit scores derived from them. The higher the score, the more creditworthy the borrower is assumed to be. Favorable interest rates are offered to buyers with high scores. Lower scores indicate higher risk for the lender, and higher rates will generally be charged to reflect the (expected) higher default rates.

A partial amortization or balloon loan is one where the amount of monthly payments due are calculated (amortized) over a certain term, but the outstanding principal balance is due at some point short of that term. This payment is sometimes referred to as a "balloon payment" or bullet payment. The interest rate for a balloon loan can be either fixed or floating. The most common way of describing a balloon loan uses the terminology X due in Y, where X is the number of years over which the loan is amortized, and Y is the year in which the principal balance is due.

Standard or conforming mortgages

Many countries have a notion of standard or conforming mortgages that define a perceived acceptable level of risk, which may be formal or informal, and may be reinforced by laws, government intervention, or market practice. For example, a standard mortgage may be considered to be one with no more than 70-80% LTV and no more than one-third of gross income going to mortgage debt.

A standard or conforming mortgage is a key concept as it often defines whether or not the mortgage can be easily sold or securitized, or, if non-standard, may affect the price at which it may be sold. In the United States, a conforming mortgage is one which meets the established rules and procedures of the two major government-sponsored entities in the housing finance market (including some legal requirements). In contrast, lenders who decide to make nonconforming loans are exercising a higher risk tolerance and do so knowing that they face more challenge in reselling the loan.
Many countries have similar concepts or agencies that define what are "standard" mortgages. Regulated lenders (such as banks) may be subject to limits or higher risk weightings for non-standard mortgages. For example, banks in Canada face restrictions on lending more than 75% of the property value; beyond this level, mortgage insurance is generally required (as of April 2007, there is a proposal to raise this limit to 80%).

Mortgage insurance

Mortgage insurance is an insurance policy designed to protect the mortgagee (lender) from any default by the mortgagor (borrower). It is used commonly in loans with a loan-to-value ratio over 80%, and employed in the event of foreclosure and repossession.

This policy is typically paid for by the borrower as a component to final nominal (note) rate, or in one lump sum up front, or as a separate and itemized component of monthly mortgage payment. In the last case, mortgage insurance can be dropped when the lender informs the borrower, or its subsequent assigns, that the property has appreciated, the loan has been paid down, or any combination of both to relegate the loan-to-value under 80%.

In the event of repossession, banks, investors, etc. must resort to selling the property to recoup their original investment (the money lent), and are able to dispose of hard assets (such as real estate) more quickly by reductions in price. Therefore, the mortgage insurance acts as a hedge should the repossessing authority recover less than full and fair market value for any hard asset.

Islamic mortgages

The Sharia law of Islam prohibits the payment or receipt of interest, which means that practising Muslims cannot use conventional mortgages. However, real estate is far too expensive for most people to buy outright using cash: Islamic mortgages solve this problem by having the property change hands twice. In one variation, the bank will buy the house outright and then act as a landlord. The homebuyer, in addition to paying rent, will pay a contribution towards the purchase of the property. When the last payment is made, the property changes hands.

Typically, this may lead to a higher final price for the buyers. This is because in some countries (such as the United Kingdom and India) there is a Stamp Duty which is a tax charged by the government on a change of ownership. Because ownership changes twice in an Islamic mortgage, a stamp tax may be charged twice. Many other jurisdictions have similar transaction taxes on change of ownership which may be levied.

An alternative scheme involves the bank reselling the property according to an installment plan, at a price higher than the original price. All of these methods are still compensating the lender as if they were charging interest, but the loans are structured in a way that in name they are not, but they share the financial risks involved in the transaction with the homebuyer.

Mortgage Loan


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