# Residential Mortgage Loans

A mortgage loan is a loan secured by real estate in which the borrower is obliged to make a predetermined series of payments. The mortgage gives the lender the right to foreclose if the borrower defaults. Foreclosure allows the lender to take possession of the mortgaged property and then sell it to recover the funds.

## Loan-to-value Ratio

Usually, the loan amount is less than the property’s purchase price as the borrower makes a down payment. The ratio of the amount of the mortgage to the value of the property is the loan-to-value ratio. For example, if a lender buys a $500,000 property and makes a down payment of$100,000, the loan-to-value ratio will be $400,000/$500,000 = 0.8. The lower the LTV, the more the lender is protected for recovering the loaned amount.

## Credit Quality of the Borrower

The two types of mortgages based on the borrower’s credit quality are prime loans and sub-prime loans. Prime (A-grade) loans take the top spot as the most desirable loans from the lender’s perspective. They are associated with low rates of delinquency and default thanks to low loan-to-value ratios, typically far less than 95%. In addition, borrowers are individuals with stable and sufficient income.

Sub-prime (B-grade) loans have higher rates of default and delinquency compared to prime loans. They are associated with loan-to-value ratios of 95% or more. Borrowers may be individuals with lower income levels and marginal/poor credit histories.

## Lien Status

A first-lien mortgage is more desirable than a second-lien mortgage from the perspective of the lender. In the event of liquidation, a first-lien status would give the lender the right to submit the first claim on the proceeds of the liquidation process.

## Interest Rate Determination

Fixed-rate mortgages are associated with a fixed rate of interest up to maturity – for example, 5% for 30 years.

Adjustable-rate mortgages (ARMs) are associated with a floating rate of interest. For example, the rate could be LIBOR + 100 bps. In such an arrangement, the rate could change every six months.

Under an initial period fixed rate, the initial period is fixed for some time and then adjusted.

A convertible mortgage rate is initially either a fixed or an adjustable rate, and at some point, the borrower has the option to shift to either a fixed or adjustable rate for the remainder of the mortgage’s life.

## Amortization Schedule

Residential mortgages are amortizing loans that have a gradual reduction of the borrowed amount over time. Most residential mortgages are fully amortizing loans. The payment is usually constant over the life of the mortgage, but the amount of principal paid in each subsequent payment keeps on increasing while the amount of interest decreases. Here is the amortization schedule on a 10-year \$250,000 loan at a 4.5% interest:

$$\begin{array}{l|c|c|c|c} \textbf{Month} & \textbf{Month 1} & \textbf{Month 2} & \textbf{Month 3} & \textbf{} \\ \hline \text{Total Payment} & \text{\2,590.96} & \text{\2,590.96} & \text{\2,590.96} & \text{Equal} \\ \text{Principal} & \text{\1,653.46} & \text{\1,663.18} & \text{\1,672.89} & \text{Increasing} \\ \text{Interest} & \text{\937.50} & \text{\927.78} & \text{\918.07} & \text{Decreasing} \\ \text{Loan Balance} & \text{\248,346.54} & \text{\246,693.08} & \text{\245,039.62} & \text{Decreasing} \\ \end{array}$$

Note 1: Interest payable is based on the amount of outstanding loan. Therefore, we will always see an increase in the principal paid on each payment.

Note 2: The loan balance only decreases by the principal amount on each payment. This is because the interest payable portion of the payment is remitted to the financial institution issuing the loan.

In a partially amortizing loan, the last payment is a “balloon” payment. If no scheduled principal repayment is specified for several years, the loan is known as an interest-only mortgage.

## Prepayment Options and Penalties

Prepayments are more likely to occur following a drop in interest rates. In such circumstances, the borrower may decide to refinance their existing mortgages at the lower rates.

Mortgage prepayments take one of two forms:

• increasing the amount/frequency of payments; or
• repaying/refinancing the entire outstanding balance.

The mortgage may stipulate some sort of monetary penalty when a borrower prepays within a certain time. These are referred to as prepayment penalty mortgages.

## Foreclosure

When the borrower fails to make contractual loan payments, the lender can repossess the property and sell it. Sometimes, however, the proceeds could be insufficient. Under a recourse loan, the lender can go after other assets of the borrower that were not used as loan collateral. In a non-recourse loan, the lender could not have such a claim and can only sell the borrower’s mortgaged property to recover the outstanding mortgage balance.

Sometimes, the value of the property declines below the outstanding debt amount. This is called an “underwater mortgage.” When mortgages are non-recourse, the borrower may have the incentive to default, which is a “strategic default.” This is one of the factors that caused the United States sub-prime mortgage crisis of 2007-2009. The risk spread into mutual funds, pension funds, and corporations who owned derivatives on these mortgages, causing a global financial crisis.

### Question

Which of the following contractual provisions would protect a lender from a “strategic default” in the case of a real estate market downturn?

1. Recourse option.
2. Early repayment option.

Solution

Under a recourse loan, the lender can go after other assets of the borrower that were not used as loan collateral. This would make the borrower less inclined to do a “strategic default,” unless they do not have any other assets.

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