Residential Mortgage Loans Explained | CFA Level I Fixed Income

Today, we’re diving into residential mortgage loans as a primer for our next lesson on mortgage-backed securities.

What is a Residential Mortgage Loan?

A residential mortgage loan is a loan where the underlying collateral is residential real estate. In case of a borrower’s default, the lender has a legal claim to the collateral property.

Lower LTV ratios are less risky for lenders, while higher LTV ratios can be risky. Lenders manage risk by tailoring LTV ratio requirements based on the borrower’s profile.

Debt-to-Income (DTI) Ratios

The DTI ratio is another critical measure, comparing expected monthly debt payments against the borrower’s pre-tax income, assessing their capability to manage debt. A lower DTI ratio indicates reduced lender risk.

Prime vs. Subprime Loans

In the U.S., prime loans are extended to borrowers with robust credit and employment histories, characterized by lower LTV and DTI ratios. Subprime loans cater to individuals with lesser credit quality, often featuring higher LTV and DTI ratios and posing greater risks to lenders.

Key Characteristics of Mortgage Loans

Mortgage loans can vary in terms of:

• Maturity
• Interest charges
• Amortization of principal
• Prepayment terms
• Lender’s rights in foreclosure

Maturity

Mortgage loans typically have terms ranging from 15 to 30 years in the United States, 20 to 40 years in many European countries, and even up to 100 years in Japan.

Interest Charges

Interest rates on mortgages can be determined in four basic ways:

• Fixed-rate mortgage: Unchanged interest rate over the life of the mortgage
• Adjustable-rate mortgage (ARM): Interest rate that can change, usually based on a market-determined reference rate
• Initial period fixed-rate mortgage: Fixed rate for an initial period, then adjusted
• Convertible mortgage: Allows the borrower to change interest rate terms during the loan period

Amortization of Principal

There are three main types of mortgage loans based on principal amortization:

• Fully amortising loan: Principal is fully repaid by maturity
• Partially amortising loan: Principal is not fully repaid, requiring a balloon payment at the end
• Interest-only mortgage loan: No principal repayment; may require a balloon payment or partial/full amortization after an initial period

Prepayment Terms

Prepayment is the partial or full repayment of the principal in excess of scheduled repayments. Some loans have no prepayment penalty, while others require an additional payment if principal is prepaid.

Lender’s Rights in Foreclosure

Foreclosure occurs when a borrower defaults on the mortgage loan. There are two types of loans based on lender’s rights:

• Non-recourse loans: The lender can only claim the collateral property, and the borrower’s other assets are not at risk.
• Recourse loans: The lender can claim the collateral property and pursue the borrower for the shortfall if the property’s value is lower than the outstanding amount owed.

In Europe, most residential mortgages are recourse loans, while in the United States, it depends on the state laws.

Conclusion

Residential mortgage loans are crucial to understanding mortgage-backed securities. We’ve covered the basics of residential mortgage loans, including key characteristics, types, and terms. With this foundation, you’re now ready to dive into the world of residential mortgage-backed securities in our next lesson.