A Primer on the Mortgage Market and Mortgage Finance
During this decade, the Standard &
Poor/Case-Shiller Home Price Index rose at a
compounded annual rate of 8.5 percent per year,
more than four times faster than the rate of inflation. Growth in home prices was particularly
strong during the period 2000-05, when home
prices rose at an annual rate of 11.4 percent.
However, since the first quarter of 2006, house
price growth has slowed dramatically; and, in
the first quarter of 2007, prices fell for the first
time since 1991. These price declines, combined
with higher interest rates, have led to increased
mortgage delinquency, especially in the subprime
mortgage market.
Federal Reserve Chairman
Bernanke reported recently that the “rate of
serious delinquencies for subprime mortgages
with adjustable interest rates…has risen to about
12 percent, roughly double the recent low seen
in mid-2005.”1 On news that the subprime woes
may spill over to borrowers with good credit, rates on mortgage-backed securities rose, while
rates on risk-free Treasury bills declined
dramatically.
Against this backdrop, this article serves as
a primer on mortgage finance. It discusses the
basics of the mortgage market and mortgage
finance, providing useful information that can
aid individuals in making better mortgage finance
decisions. Although the discussion and the tools
are presented within the context of mortgage
finance, these same principles and tools can be
applied to a wide range of financial decisions.
ETYMOLOGY
The term mortgage comes from the Old
French, and literally means “death vow.” This
refers not to the death of the borrower, but to the
“death” of the loan. This is because mortgages,
like many other types of loans, have a fixed term
to maturity that is, a date at which the loan is
to be fully repaid.
Today, mortgages are paid in installments (most often, monthly), so that the
loan is repaid over time rather than as a lump sum
on the maturity date. The word for this repayment
is amortization, which derives from the Middle
English for “kill.”
It refers not to the borrower’s
murder, but to “killing off” the mortgage by paying it down over time. The morbid etymology of
these real estate terms must have some subliminal
impact on potential borrowers, as many continue
to find the process of getting a mortgage unnerving; however, a mortgage is nothing to be afraid
of, as we hope to demonstrate in the remainder
of this article.
MORTGAGE BASICS
“Mortgage” is nothing more than the name
given to a particular type of loan; in this case, a
real estate loan.
3 Like any other loan, it is really an
IOU—that is, a promise to repay a sum of money
received today at some future time.
Although the
names of loans change for a variety of reasons,
they all have the same basic characteristics: the
loan amount, the loan term, the schedule for
repayment, and the contract interest rate.
The amount of a loan is just that a sum of
money that the borrower receives upon signing
the loan agreement. The term (or maturity) of the
loan is the length of time over which the loan
amount is to be repaid. The schedule for repayment simply states how the loan is to be repaid.
Loans can be repaid in installments over the term
of the mortgage, in a lump sum at the terminal
date of the contract, or in some combination of
installments and a final lump sum payment. In
the case of mortgages, auto loans, and other consumer loans, the convention is that the loan is
repaid in fixed periodic payments, typically
monthly.
The contract interest rate is the interest
rate that the borrower pays the lender in exchange
for having the money today.
There are two risks associated with lending.
The first, called default risk, is the possibility
that the borrower fails to repay the loan.
The second, called market risk, arises when interest rates
change over time. If market interest rates rise
after the lender has offered a mortgage contract,
not only will the lender earn less interest than
he would have had he waited and lent at the
higher interest rate, but the market value of the
investment will decline.
Of course, the reverse is
also true: If market interest rates fall, the lender
will earn more interest than if he waited and the
market value of his investment will increase.
The risk is due to the fact that it is very difficult
to predict whether interest rates will rise or fall.
The lender also risks losing the higher interest
he would earn if the individual decides to refinance the loan at a lower rate.
The prospect of default has led societies to
develop laws and mechanisms to protect the
lender.
One of these is collateral an asset owned
by the borrower that becomes the lender’s in the
event that the borrower fails to repay the loan. In
the case of mortgages, the collateral is nearly
always the property being purchased. Loan agreements may also contain a variety of restrictions.
Some of these are intended to protect the lender,
while others protect the borrower. For example,
in the past, many mortgages were “assumable,”
meaning that if the borrower sold the house, the
mortgage could be assumed or transferred to the
new owner.
This hurt lenders when interest rates
rose because the new owner could get a “belowmarket interest rate” by assuming the previous
mortgage. Today, mortgages are typically not
assumable. There was also a time when many
mortgages (and other consumer loan contracts)
had a prepayment penalty.
That is, the lender
could assess a fee if the borrower repaid the loan
before the terminal date of the contract. Presentday mortgage contracts typically stipulate that
there is no penalty for paying the loan off before
its maturity date.
Types of Mortgages
There are a number of different types of mortgages, but the most common are the fixed-rate
mortgage and the adjustable-rate mortgage (or
ARM). Other types tend to be combinations of these two. Fixed-rate mortgages are by far the
most common type of mortgage, accounting for
about 70 percent of the total mortgage market.
 |
| Market Share of Fixed-Rate Mortgages and Contract Interest Rate |
Figure 1 shows the percentage of the total mortgage market accounted for by 15- and 30-year
fixed-rate mortgages since 1990 as well as the
average contract interest rate. One would expect
that lower contract interest rates would lead to a
higher percentage of fixed-rate mortgages, as borrowers try to lock in low rates.
This relationship
seems to hold true over most of the period, but
breaks down after 2002. The benefits of a fixedrate mortgage are as follows: (i) the monthly payment (interest and principal) is constant for the
term of the mortgage and (ii), regardless of the
behavior of market interest rates, the interest rate
paid by the borrower is the same for the life of
the loan.
ARMs, however, have interest rates that vary
over the term of the loan in step with some index.
The two most common indices are the Eleventh
Federal Home Loan Bank Board District Cost of
Funds Index (COFI) and the National Cost of
Funds Index.
ARMs have various features depending on the mortgage broker. Most often, an introductory rate is fixed for a period of time ranging
from 2 to 5 years. Following this period, the
interest rate will rise or fall with the index (plus
a fixed markup called the margin) at some specified time interval, generally every six months.
Typically, the amount that the interest rate can
rise or fall in a particular interval is limited and
upper and lower bounds for the interest rate
over the life of the loan are set.
Rates on ARMs are lower than on otherwise
equivalent fixed-rate mortgages.
The reason is
that the borrower is bearing some of the market
risk. Market risk arises because of the inverse (or
negative) relationship between interest rates and
bond prices. Specifically, if the market interest
rate rises, the value of the bond (mortgage) falls
and vice versa.
For example, consider the effect
of an increase in the market interest rate on the
market value of a 30-year, $200,000, 5 percent
fixed-rate mortgage. The price of the 30-year mortgage decreases by $20,925.31 (from $200,000 to
$179,074.69) if the market interest rate rises from
5 percent to 6 percent.
If the holder of the mortgage were to sell it, they would suffer what is
referred to as a capital loss. Moreover, the price
of a longer-term mortgage falls by more than the
price of a shorter-term mortgage for a given
increase in market interest rates.
 |
| Comparing Effective Interest Rates |
For example, the price of a 5-year mortgage would have decreased
by just $4,774.97 (from $200,000 to $195,225.03)
with the same increase in the interest rate (from
5 percent to 6 percent). Because mortgages have
maturities that are relatively long up to 30 years,
they have a relatively high degree of market risk.
Of course, the reverse is also true.
If the market
interest rate were to fall, the value of the mortgage
would rise and the holder of the mortgage would
realize a capital gain. The problem is that interest
rates are extremely difficult to predict.
If the markets were populated by investors who are indifferent to whether they sustain a capital loss or a
capital gain (i.e., indifferent to risk), the fact that
bond prices and interest rates are inversely related
would not be an issue. Interest rates would be
invariant to the maturity of the asset.
However,
financial markets are populated by risk-adverse
lenders (i.e., those more concerned with suffering
a capital loss than a getting a capital gain). Consequently, there is a risk premium on bonds (including mortgages) that increases as the term of the
loan increases.
The risk premium is tiny essentially zero for loans of only a few months. The
risk premium for 30-year loans can be fairly
large, depending on market circumstances.
Because the interest rates on ARMs adjust
over the term of the loan, ARMs have less market
risk than the corresponding fixed-rate loan with
the same maturity. Consequently, with an ARM,
some of the market risk associated with mortgage
lending is assumed by the borrower.
As noted
earlier, like anything else, risk is priced. Hence,
ARMs have an initial rate that is lower than the
rate on an otherwise equivalent-maturity fixedrate loan. Table 1 shows the annual average difference between the initial rates on conforming
fixed-rate mortgages and ARMs from 1997 to
2004.
The differences vary from year to year, but
range from about 50 to about 100 basis points.
4
Because ARMs have a lower initial interest rate,
they are particularly good for individuals who
plan either to sell their house or pay off the loan
after a short period of time.
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