Chapter+14+The+Mortgage+Markets

The Mortgage Markets

PreviewPart of the classic American dream is to own one’s own home. With the price ofthe average house now over $235,000, few of us could hope to do this untillate in life if we were not able to borrow the bulk of the purchase price.Similarly, businesses rely on borrowed capital far more than on equity invest-ment to finance their growth. Many small firms do not have access to the bondmarket and must find alternative sources of funds. Consider the state of themortgage loan markets 100 years ago. They were organized mostly to accom-modate the needs of businesses and the very wealthy. Much has changed sincethen. The purpose of this chapter is to discuss these changes.

Chapter 11 discussed the money markets, the markets for short-termfunds. Chapters 12 and 13 discussed the bond and stock markets. This chapterdiscusses the mortgage markets, where borrowers—individuals, businesses,and governments—can obtain long-term collateralized loans. From one per-spective, the mortgage markets form a subcategory of the capital marketsbecause mortgages involve long-term funds. But the mortgage markets differfrom the stock and bond markets in important ways. First, the usual borrowersin the capital markets are government entities and businesses, whereas theusual borrowers in the mortgage markets are individuals. Second, mortgageloans are made for varying amounts and maturities, depending on the borrow-ers’ needs, features that cause problems for developing a secondary market.

In this chapter we will identify the characteristics of typical residential mort-gages, discuss the usual terms and types of mortgages available, and reviewwho provides and services these loans. We will also continue the discussion ofissues in the mortgage-backed security market and the recent crash of thesubprime mortgage market begun in Chapter 8.

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324 Part 5 Financial Markets

What Are Mortgages?A mortgage is a long-term loan secured by real estate. A developer may obtain a mort-gage loan to finance the construction of an office building, or a family may obtain amortgage loan to finance the purchase of a home. In either case, the loan is amortized:

The borrower pays it off over time in some combination of principal and interest pay-ments that result in full payment of the debt by maturity. Table 14.1 shows the dis-tribution of mortgage loan borrowers. Because over 81% of mortgage loans financeresidential home purchases, that will be the primary focus of this chapter.

One way to understand the modern mortgage is to review its history. Originally,many states had laws that prevented banks from funding mortgages so that bankswould not tie up their funds in long-term loans. The National Banking Act of 1863further restricted mortgage lending. As a result, most mortgage contracts in thepast were arranged between individuals, usually with the help of a lawyer whobrought the parties together and drew up the papers. Such loans were generally avail-able only to the wealthy and socially connected. As the demand for long-term fundsincreased, however, more mortgage brokers surfaced. They often originated loansin the rapidly developing western part of the country and sold them to savings banksand insurance companies in the East.

By 1880, mortgage bankers had learned to streamline their operations by sell-ing bonds to raise the long-term funds they lent. They would gather a portfolio ofmortgage contracts and use them as security for an issue of bonds that were sold pub-licly. Many of these loans were used to finance agricultural expansion in the Midwest.Unfortunately, an agricultural recession in the 1890s resulted in many defaults. Landprices fell, and a large number of the mortgage bankers went bankrupt. It becamevery difficult to obtain long-term loans until after World War I, when national bankswere authorized to make mortgage loans. This regulatory change caused a tremen-dous real estate boom, and mortgage lending expanded rapidly.

The mortgage market was again devastated by the Great Depression in the 1930s.Millions of borrowers were without work and were unable to make their loan pay-ments. This led to foreclosures and land sales that caused property values to collapse.Mortgage-lending institutions were again hit hard, and many failed.

One reason that so many borrowers defaulted on their loans was the type of mort-gage loan they had. Most mortgages in this period were balloon loans: The borrowerpaid only interest for three to five years, at which time the entire loan amount becamedue. The lender was usually willing to renew the debt with some reduction in prin-cipal. However, if the borrower were unemployed, the lender would not renew, andthe borrower would default.

TA B L E 1 4 . 1 Mortgage Loan Borrowing, 2009

Type of PropertyMortgage Loans

Issued ($ millions)Proportion of Total (%)

One- to four-family dwelling 10,772 75.4

Multifamily dwelling 899 6.29

Commercial building 2,477 17.34

Farm 138 .97

Source: Federal Reserve Bulletin, 2010, Table 1.54.

Chapter 14 The Mortgage Markets 325

As part of the recovery program from the Depression, the federal governmentstepped in and restructured the mortgage market. The government took over delin-quent balloon loans and allowed borrowers to repay them over long periods of time.It is no surprise that these new types of loans were very popular. The surviving sav-ings and loans began offering home buyers similar loans, and the high demand con-tributed to restoring the health of the mortgage industry.

Characteristics of the Residential MortgageThe modern mortgage lender has continued to refine the long-term loan to make itmore desirable to borrowers. Even in the past 20 years, both the nature of the lendersand the instruments have undergone substantial changes. One of the biggest changesis the development of an active secondary market for mortgage contracts. We will exam-ine the nature of mortgage loan contracts and then look at their secondary market.

Twenty years ago, savings and loan institutions and the mortgage departments oflarge banks originated most mortgage loans. Some were maintained in-house by the orig-inator while others were sold to one of a few firms. These firms closely tracked delin-quency rates and would refuse to continue buying loans from banks where delinquencieswere very high. More recently, many loan production offices arose that competed in realestate financing. Some of these offices are subsidiaries of banks, and others are inde-pendently owned. As a result of the competition for mortgage loans, borrowers couldchoose from a variety of terms and options. Many of these mortgage businesses wereorganized around the originate-to-distribute model where the broker originated the loanand sold it to an investor as quickly as possible. This model increased the principal–agentproblem since the originator had little concern whether the loan was actually paid off.

Mortgage Interest RatesThe interest rate borrowers pay on their mortgages is probably the most importantfactor in their decision of how much and from whom to borrow. The interest rateon the loan is determined by three factors: current long-term market rates, the life(term) of the mortgage, and the number of discount points paid.

1. Market rates. Long-term market rates are determined by the supply of anddemand for long-term funds, which are in turn influenced by a number ofglobal, national, and regional factors. As Figure 14.1 shows, mortgage ratestend to stay above the less risky Treasury bonds most of the time but tendto track along with them.

2. Term. Longer-term mortgages have higher interest rates than shorter-termmortgages. The usual mortgage lifetime is either 15 or 30 years. Lenders alsooffer 20-year loans, though they are not as popular. Because interest-rate riskfalls as the term to maturity decreases, the interest rate on the 15-year loanwill be substantially less than on the 30-year loan. For example, in May 2010,the average 30-year mortgage rate was 4.75%, and the 15-year rate was 4.2%.

3. Discount points. Discount points (or simply points) are interest paymentsmade at the beginning of a loan. A loan with one discount point means that theborrower pays 1% of the loan amount at closing, the moment when the borrowersigns the loan paper and receives the proceeds of the loan. In exchange for thepoints, the lender reduces the interest rate on the loan. In considering whetherto pay points, borrowers must determine whether the reduced interest rateover the life of the loan fully compensates for the increased up-front expense.

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To make this determination, borrowers must take into account how long theywill hold on to the loan. Typically, discount points should not be paid if the bor-rower will pay off the loan in five years or less. This breakeven point is notsurprising since the average home sells every five years.

0

4

8

10

12

6

199519931991198919871985

InterestRates (%)

200119991997 2003 2005 20092007

Mortgage Interest Rates

Long-TermTreasury

Rates

F I G U R E 1 4 . 1 Mortgage Rates and Long-Term Treasury Interest Rates, 1985–2009

Source: Federal Reserve Bulletin, various issues, Table 1.53 Line 7 and Table 1.35 Line 23.

C A S E

The Discount Point Decision

Suppose that you are offered two loan alternatives. In the first, you pay no discountpoints and the interest rate is 12%. In the second, you pay 2 discount points butreceive a lower interest rate of 11.5%. Which alternative do you choose?

To answer this question you must first compute the effective annual rate with-out discount points. Since the loan is compounded monthly, you pay 1% per month.Because of the compounding, the effective annual rate is greater than the simpleannual rate. To compute the effective rate, raise 1 plus the monthly rate to the12th power and subtract 1. The effective annual rate on the no-point loan is thus

Because of monthly compounding, a 12% annual percentage rate has an effectiveannual rate of 12.68%. On a 30-year, $100,000 mortgage loan, your payment will be$1,028.61 as found on a financial calculator.

Now compute the effective annual rate if you pay 2 discount points. Let’s assumethat the amount of the loan is still $100,000. If you pay 2 points, instead of receiving

Effective annual rate � 11.01212 � 1 � 0.1268 � 12.68%


TABLE 14 .2 Effective Rate of Interest on a Loan at 12% with 2 Discount Points

Year ofPrepayment

Effective Rate of Interest (%)

Year ofPrepayment

Effective Rate of Interest (%)

1 14.54 6 12.65

2 13.40 7 12.60

3 13.02 10 12.52

4 12.84 15 12.45

5 12.73 30 12.42.

1See Chapter 3 for a discussion on how loan payments are computed.2For example, to compute the effective rate if the loan is prepaid after two years, find the FV if

I = 11.5%, PV = 100,000, N = 360, and PMT = 990.29. Now set PV equal to 98,000 and compute I.Divide this I by 12, add 1, and raise the result to the 12th power.

$100,000, you will receive only $98,000 ($100,000 – $2000). Your payment is computedon the $100,000, but at the lower interest rate. Using a financial calculator, we findthat the monthly payment is $990.29 and your monthly rate is 0.9804%.1 The effec-tive annual rate after compounding is

As a result of paying the 2 discount points, the effective annual rate has droppedfrom 12.68% to 12.42%. On the surface, it would seem like a good idea to pay thepoints. The problem is that these calculations were made assuming the loan wouldbe held for the life of the loan, 30 years. What happens if you sell the house beforethe loan matures?

If the loan is paid off early, the borrower will benefit from the lower interestrate for a shorter length of time, and the discount points are spread over a shorterperiod of time. The result of these two factors is that the effective interest rate risesthe shorter the time the loan is held before being paid. This relationship is demon-strated in Table 14.2. If the 2-point loan is held for 15 years, the effective rate is12.45%. At 10 years, the effective rate is up to 12.52%. Even at 6 years, when theeffective rate is 12.65%, paying the discount points has saved the borrower money.However, if the loan is paid off at 5 years, the effective rate is 12.73%, which is higherthan the 12.68% effective rate if no points were paid.2

Effective annual rate � 11.009804212 � 1 � 0.1242 � 12.42%

Loan TermsMortgage loan contracts contain many legal and financial terms, most of which pro-tect the lender from financial loss.

Collateral One characteristic common to mortgage loans is the requirement thatcollateral, usually the real estate being financed, be pledged as security. The lend-ing institution will place a lien against the property, and this remains in effect untilthe loan is paid off. A lien is a public record that attaches to the title of the property,


advising that the property is security for a loan, and it gives the lender the right tosell the property if the underlying loan defaults.

No one can buy the property and obtain clear title to it without paying off thislien. For example, if you purchased a piece of property with a loan secured by alien, the lender would file notice of this lien at the public recorder’s office. The liengives notice to the world that if there is a default on the loan, the lender has theright to seize the property. If you try to sell the property without paying off the loan,the lien would remain attached to the title or deed to the property. Since the lendercan take the property away from whoever owns it, no one would buy it unless youpaid off the loan. The existence of liens against real estate explains why a title searchis an important part of any mortgage loan transaction. During the title search, a lawyeror title company searches the public record for any liens. Title insurance is thensold that guarantees the buyer that the property is free of encumbrances, any ques-tions about the state of the title to the property, including the existence of liens.

Down Payments To obtain a mortgage loan, the lender also requires the borrowerto make a down payment on the property, that is, to pay a portion of the pur-chase price. The balance of the purchase price is paid by the loan proceeds. Downpayments (like liens) are intended to make the borrower less likely to default on theloan. A borrower who does not make a down payment could walk away from thehouse and the loan and lose nothing. Furthermore, if real estate prices drop evena small amount, the balance due on the loan will exceed the value of the collateral.As we discussed in Chapters 2 and 8, the down payment reduces moral hazard

for the borrower. The amount of the down payment depends on the type of mort-gage loan. Beginning in the mid 2000s the required down payment was often cir-cumvented with piggy back loans where a second mortgage was added to the firstso that 100% financing was provided.

Private Mortgage Insurance Another way that lenders protect themselves againstdefault is by requiring the borrower to purchase private mortgage insurance (PMI).

PMI is an insurance policy that guarantees to make up any discrepancy between thevalue of the property and the loan amount, should a default occur. For example, ifthe balance on your loan was $120,000 at the time of default and the property was worthonly $100,000, PMI would pay the lending institution $20,000. The default still appearson the credit record of the borrower, but the lender avoids sustaining the loss. PMI isusually required on loans that have less than a 20% down payment. If the loan-to-value ratio falls because of payments being made or because the value of the prop-erty increases, the borrower can request that the PMI requirement be dropped. PMIusually costs between $20 and $30 per month for a $100,000 loan.

Ideally, PMI should have protected investors against losses on mortgage invest-ments, and it did until recently. PMI is usually only required on the first mortgage. Bystructuring loans so that the first mortgage loan was set at 80% loan to value witha second mortgage covering the remaining 20%, PMI was avoided.

Borrower Qualification Historically, before granting a mortgage loan, the lender woulddetermine whether the borrower qualified for it. Qualifying for a mortgage loan wasdifferent from qualifying for a bank loan because most lenders sold their mortgage loansto one of a few federal agencies in the secondary mortgage market. These agencies estab-lished very precise guidelines that had to be followed before they would accept the loan.If the lender gave a mortgage loan to a borrower who did not fit these guidelines, thelender would not be able to resell the loan. That tied up the lender’s funds.


The rules for qualifying a borrower were complex and constantly changing, buta rule of thumb was that the loan payment, including taxes and insurance, should notexceed 25% of gross monthly income. Furthermore, the sum of the monthly paymentson all loans to the borrower, including car loans and credit cards, should not exceed33% of gross monthly income.

Lenders will also order a credit report from one of the major credit reportingagencies. The credit score is based on a model that weights a number of variablesfound to be valid predictors of credit worthiness. The most common score is calledthe FICO, named after its creator, Fair Isaac Company. FICO scores may range froma low of 300 to a maximum of 850. Scores above 720 are considered good while scoresbelow 660 were likely to cause problems obtaining a loan. The FICO score is deter-mined by your past payment history, outstanding debt, length of credit history, num-ber or recent credit applications, and types of credit and loans you have. It isinteresting to note that simply applying for and holding a number of credit cardscan significantly affect your FICO score.

When the competition to originate mortgage loans grew in the mid 2000s, a vari-ety of mortgage loans were offered that circumvented traditional lending practices.For example, borrowers were offered No Doc loans (sometimes called NINJA loansfor No Income, No Job, and No Assets) where income or assets were not requiredon the loan application. These lending practices have been largely abandoned asthe search for quality borrowers has replaced the need for loan volume.

Mortgage Loan AmortizationMortgage loan borrowers agree to pay a monthly amount of principal and interest thatwill fully amortize the loan by its maturity. “Fully amortize” means that the paymentswill pay off the outstanding indebtedness by the time the loan matures. During theearly years of the loan, the lender applies most of the payment to the interest onthe loan and a small amount to the outstanding principal balance. Many borrowersare surprised to find that after years of making payments, their loan balance hasnot dropped appreciably.

Table 14.3 shows the distribution of principal and interest for a 30-year, $130,000 loan at 8.5% interest. Only $78.75 of the first payment is applied to reducethe loan balance. At the end of two years, the balance due is still $127,947, and at theend of five years, the balance due is $124,137. Put another way, of $59,975.40 in

TA B L E 1 4 . 3 Amortization of a 30-Year, $130,000 Loan at 8.5%

PaymentNumber

BeginningBalance of Loan

MonthlyPayment

Amount Applied to Interest

Amount Applied to Principal

Ending Balance of Loan

1 130,000.00 999.59 920.83 78.75 129,921.24

24 128,040.25 999.59 906.95 92.66 127,947.62

60 124,256.74 999.59 880.15 119.43 124,137.31

120 115,365.63 999.59 817.17 182.41 115,183.22

180 101,786.23 999.59 720.99 278.60 101,507.63

240 81,046.41 999.59 574.08 425.51 80,620.90

360 991.77 999.59 7.82 991.77 0


loan payments made during the first five years, only $5,862.69 is applied to the prin-cipal. Over the life of the $130,000 loan, a total of $229,850 in interest will be paid.

If the loan in Table 14.3 had been financed for 15 years instead of for 30, the pay-ment would have increased by about $280 per month to $1,279.59, but the interestsavings over the life of the loan would be nearly $130,000. It is no wonder why somany borrowers prefer the shorter-term loans.

Types of Mortgage LoansA number of types of mortgage loans are available in the market. Different borrow-ers may qualify for different ones. A skilled mortgage banker can help find the besttype of mortgage loan for each particular situation.

Insured and Conventional MortgagesMortgages are classified as either insured or conventional. Insured mortgages areoriginated by banks or other mortgage lenders but are guaranteed by either theFederal Housing Administration (FHA) or the Veterans Administration (VA).Applicants for FHA and VA loans must meet certain qualifications, such as havingserved in the military or having income below a given level, and can borrow onlyup to a certain amount. The FHA or VA then guarantees the bank making the loansagainst any losses—that is, the agency guarantees that it will pay off the mortgageloan if the borrower defaults. One important advantage to a borrower who qualifiesfor an FHA or VA loan is that only a very low or zero down payment is required.

Conventional mortgages are originated by the same sources as insured loansbut are not guaranteed. Private mortgage companies now insure many conventionalloans against default. As we noted, most lenders require the borrower to obtain pri-vate mortgage insurance on all loans with a loan-to-value ratio exceeding 80%.

Fixed- and Adjustable-Rate MortgagesIn standard mortgage contracts, borrowers agree to make regular payments on theprincipal and interest they owe to lenders. As we saw earlier, the interest rate sig-nificantly affects the size of this monthly payment. In fixed-rate mortgages, the inter-est rate and the monthly payment do not vary over the life of the mortgage.

The interest rate on adjustable-rate mortgages (ARMs) is tied to some mar-ket interest rate and therefore changes over time. ARMs usually have limits, calledcaps, on how high (or low) the interest rate can move in one year and during the termof the loan. A typical ARM might tie the interest rate to the average Treasury bill rateplus 2%, with caps of 2% per year and 6% over the lifetime of the mortgage. Capsmake ARMs more palatable to borrowers.

Borrowers tend to prefer fixed-rate loans to ARMs because ARMs may causefinancial hardship if interest rates rise. However, fixed-rate borrowers do not bene-fit if rates fall unless they are willing to refinance their mortgage (pay it off by obtain-ing a new mortgage at a lower interest rate). The fact that individuals are risk-aversemeans that fear of hardship most often overwhelms anticipation of savings.

Lenders, by contrast, prefer ARMs because ARMs lessen interest-rate risk. Recallfrom Chapter 3 that interest-rate risk is the risk that rising interest rates will cause thevalue of debt instruments to fall. The effect on the value of the debt is greatest whenthe debt has a long term to maturity. Since mortgages are usually long-term, their value


is very sensitive to interest-rate movements. Lending institutions can reduce thesensitivity of their portfolios by making ARMs instead of standard fixed-rate loans.

Seeing that lenders prefer ARMs and borrowers prefer fixed-rate mortgages,lenders must entice borrowers by offering lower initial interest rates on ARMs than onfixed-rate loans. For example, in May 2010, the reported interest rate for 30-year fixed-rate mortgage loans was 4.75%. The rate at that time for 5-year adjustable-rate mort-gages was 3.625%. The rate on the ARM would have to rise 1.13% before the borrowerof the ARM would be in a worse position than the fixed-rate borrower.

Other Types of MortgagesAs the market for mortgage loans became more competitive, lenders offered moreinnovative mortgage contracts in an effort to attract borrowers. We discuss some ofthese mortgages here.

Graduated-Payment Mortgages (GPMs) Graduated-payment mortgages are use-ful for home buyers who expect their incomes to rise. The GPM has lower paymentsin the first few years; then the payments rise. The early payments may not even besufficient to cover the interest due, in which case the principal balance increases.As time passes, the borrower expects income to increase so that the higher pay-ment will not be a burden.

The advantage of the GPM is that borrowers will qualify for a larger loan thanif they requested a conventional mortgage. This may help buyers purchase ade-quate housing now and avoid the need to move to more expensive homes as theirfamily size increases. The disadvantage is that the payments escalate whether theborrower’s income does or not.

Growing-Equity Mortgages (GEMs) Lenders designed the growing-equity mort-gage loan to help the borrower pay off the loan in a shorter period of time. With aGEM, the payments will initially be the same as on a conventional mortgage. However,over time the payment will increase. This increase will reduce the principal morequickly than the conventional payment stream would. For example, a typical contractmay call for level payments for the first two years. The payments may increase by 5%per year for the next five years, then remain the same until maturity. The result isto reduce the life of the loan from 30 years to about 17.

GEMs are popular among borrowers who expect their incomes to rise in thefuture. It gives them the benefit of a small payment at the beginning while still retir-ing the debt early. Although the increase in payments is required in GEMs, most mort-gage loans have no prepayment penalty. This means that a borrower with a 30-yearloan could create a GEM by simply increasing the monthly payments beyond whatis required and designating that the excess be applied entirely to the principal.

The GEM is similar to the graduated-payment mortgage; the difference is thatthe goal of the GPM is to help the borrower qualify by reducing the first few years’payments. The loan still pays off in 30 years. The goal of the GEM is to let the bor-rower pay off early.

Second Mortgages (Piggyback) Second mortgages are loans that are secured bythe same real estate that is used to secure the first mortgage. The second mortgageis junior to the original loan. This means that should a default occur, the second mort-gage holder will be paid only after the original loan has been paid off and only ifsufficient funds are available from selling the property.


Originally second mortgages had two purposes. The first is to give borrowers away to use the equity they have in their homes as security for another loan. Analternative to the second mortgage would be to refinance the home at a higher loanamount than is currently owed. The cost of obtaining a second mortgage is oftenmuch lower than refinancing.

Another purpose of the second mortgage is to take advantage of one of the fewremaining tax deductions available to the middle class. The interest on loans securedby residential real estate is tax-deductible (the tax laws allow borrowers to deductthe interest on the primary residence and one vacation home). No other kind ofconsumer loan has this tax deduction. Many banks now offer lines of credit securedby second mortgages. In most cases, the value of the security is not of great inter-est to the bank. Consumers prefer that the line of credit be secured so that theycan deduct the interest on the loan from their taxes.

As mentioned earlier, a contributing factor in the mortgage market collapse wasthe use of second mortgage loans to reduce or eliminate the need for a down pay-ment. Borrowers who had no real equity in the home were willing to walk away onceits value dropped or their income fell. The use of second mortgages represented achange in usual lending practices. Historically, borrowers had to prove they had therequired down payment before the loan would move forward.

Reverse Annuity Mortgages (RAMs) The reverse annuity mortgage is an innov-ative method for retired people to live on the equity they have in their homes. Thecontract for a RAM has the bank advancing funds on a monthly schedule. Thisincreasing-balance loan is secured by the real estate. The borrower does not makeany payments against the loan. When the borrower dies, the borrower’s estate sellsthe property to retire the debt.

The advantage of the RAM is that it allows retired people to use the equity intheir homes without the necessity of selling it. For retirees in need of supplementalfunds to meet living expenses, the RAM can be a desirable option.

Option ARM The ARM discussed previously was subject to interest-rate risk butretained the basics of rational lending standards. In the mid 2000s the option arm wasmarketed under various names. In essence, it gave the borrower the “option” ofreducing the monthly payment. As a result, instead of reducing the mortgage balanceover time, as with a conventional mortgage, the amount owed steadily increased.These loans were often packaged with initial teaser rates that set the initial inter-est rate very low, then increased it substantially after a year or so. For example, thepayment on a $150,000 loan could be $125 to start, then jump to $900 after a year.With the borrower exercising the option of reducing the payment, the loan balancewould build by $775 per month.

Between 2004 and 2008 various mortgage loan options were offered that wereintended to allow almost any borrower to qualify. The argument at the time wasthat home prices have usually gone up and if a borrower could not continue toafford the mortgage, they could simply sell the home at a profit. When the hous-ing bubble burst and prices fell, this was not an option and many loans defaulted.Since 2008, the mortgage industry has largely stopped offering these high-riskloan options.

The various mortgage types are summarized in Table 14.4.


TA B L E 1 4 . 4 Summary of Mortgage Types

Conventional mortgage Loan is not guaranteed; usually requires private mortgageinsurance; 5% to 20% down payment

Insured mortgage Loan is guaranteed by FHA or VA; low or zero down payment

Adjustable-ratemortgage (ARM)

Interest rate is tied to some other security and is adjusted periodically; size of adjustment is subject to annual limits

Graduated-paymentmortgage (GPM)

Initial low payment increases each year; loan amortizes in30 years

Growing-equitymortgage (GEM)

Initial payment increases each year; loan amortizes in lessthan 30 years

Second mortgage Loan is secured by a second lien against the real estate; oftenused for lines of credit or home improvement loans

Reverse annuity mortgage

Lender disburses a monthly payment to the borrower on anincreasing-balance loan; loan comes due when the realestate is sold

Mortgage-Lending InstitutionsOriginally, the thrift industry was established with the mandate from Congress to pro-vide mortgage loans to families. Congress gave these institutions the ability to attractdepositors by allowing S&Ls to pay slightly higher interest rates on deposits. Formany years, the thrift industry did its job well. Thrifts raised short-term funds byattracting deposits and used these funds to make long-term mortgage loans. The earlygrowth of the housing industry owes much of its success to these institutions. (Thethrift industry is discussed further in Web Chapter 25.)

Until the 1970s, interest rates remained relatively stable, and when fluctuationsdid occur, they tended to be small and short-lived. But in the 1970s, interest ratesrose rapidly, along with inflation, and thrifts became the victims of interest-rate risk.As market interest rates rose, the value of their fixed-rate mortgage loan portfoliosfell. Because of the losses the thrifts suffered, they stopped being the primary sourceof mortgage loans.

Another serious problem with the early mortgage market was that thrift insti-tutions were restricted from nationwide branching by federal and state laws and wereforbidden to lend outside of their normal lending territory, about 100 miles from theiroffices. So even if an institution appeared very diversified, with thousands of differ-ent loans, all of the loans were from the same region. When that region had economicproblems, many of the loans would default at the same time. For example, Texasand Oklahoma experienced a recession in the mid-1980s due to falling oil prices. Manymortgage loans defaulted because real estate values fell at the same time as theregion’s unemployment rate rose. That other areas of the country remained healthywas of no help to local lenders.

Figure 14.2 shows the share of the total mortgage market held by the major mortgage-lending institutions in the United States. By far the largest investor are mort-gage pools and trusts. (Mortgage pools and trusts are discussed later in this chapter.)


Loan ServicingMany of the institutions making mortgage loans do not want to hold large portfoliosof long-term securities. Commercial banks, for example, obtain their funds from short-term sources. Investing in long-term loans would subject them to unacceptably highinterest-rate risk. Commercial banks, thrifts, and most other loan originators do, how-ever, make money through the fees that they earn for packaging loans for otherinvestors to hold. Loan origination fees are typically 1% of the loan amount, thoughthis varies with the market.

Once a loan has been made, many lenders immediately sell the loan to anotherinvestor. The borrower may not even be aware that the original lender transferredthe loan. By selling the loan, the originator frees up funds that can be lent to anotherborrower, thereby generating additional fee income.

Some of the originators also provide servicing of the loan. The loan-servicingagent collects payments from the borrower, passes the principal and interest on tothe investor, keeps required records of the transaction, and maintains reserve

accounts. Reserve accounts are established for most mortgage loans to permit thelender to make tax and insurance payments for the borrower. Lenders prefer to makethese payments because they protect the security of the loan. Loan-servicing agentsusually earn 0.5% per year of the total loan amount for their efforts.

In summary, there are three distinct elements to most mortgage loans:

1. The originator packages the loan for an investor.2. The investor holds the loan.3. The servicing agent handles the paperwork.

One, two, or three different intermediaries may provide these functions for anyparticular loan.

Mortgage loans are increasingly obtained from the Web. The E-Finance box dis-cusses this new source of mortgage loans.

Commercial Banks26%

Savings and Loans5%

Mortgage Pools and Trusts53%

Federal Agencies and Other14%

Life Insurance Companies2%

F I G U R E 1 4 . 2 Share of the Mortgage Market Held by Major Mortgage-Lending Institutions

Source: Federal Reserve Bulletin, April 2010, Table 1.54.


Secondary Mortgage MarketThe federal government founded the secondary market for mortgages. As we notedearlier, the mortgage market had all but collapsed during the Great Depression. Tohelp spur the nation’s economic activity, the government established several agen-cies to buy mortgages. The Federal National Mortgage Association (Fannie Mae) wasset up to buy mortgages from thrifts so that these institutions could make more mort-gage loans. This agency would fund these purchases by selling bonds to the public.

At about the same time, the Federal Housing Administration was establishedto insure certain mortgage contracts. This made it easier to sell the mortgagesbecause the buyer did not have to be concerned with the borrower’s credit historyor the value of the collateral. A similar insurance program was set up through theVeterans Administration to insure loans to veterans after World War II.

One advantage of the insured loans was that they were required to be writtenon a standard loan contract. This standardization was an important factor in thegrowth of the secondary market for mortgages.

As the secondary market for mortgage contracts took shape, a new interme-diary, the mortgage bank, emerged. Because this firm did not accept deposits, itwas able to open offices across the country. The mortgage bank originated theloans, funding them initially with its own capital. After a group of similar loans weremade, they would be bundled and sold, either to one of the federal agencies orto an insurance or pension fund. There were several advantages to the mortgagebanks. Because of their size, they were able to capture economies of scale in loan

E - F I N A N C E

Borrowers Shop the Web for Mortgages

One business area that has been significantly affectedby the Web is mortgage banking. Historically, bor-rowers went to local banks, savings and loans, andmortgage banking companies to obtain mortgageloans. These offices packaged the loans and resoldthem. In recent years, hundreds of new Web-basedmortgage banking companies have emerged.

The mortgage market is well suited to providingonline service for several reasons. First, it is information-based and no products have to be shipped or invento-ried. Second, the product (a loan) is homogeneousacross providers. A borrower does not really care whoprovides the money as long as it is provided efficiently.Third, because home buyers tend not to obtain mort-gage loans very often, they have little loyalty to anylocal lender. Finally, online lenders can often offerloans at lower cost because they can operate withlower overhead than firms that must greet the public.

The online mortgage market makes it much easierfor borrowers to shop interest rates and terms. By

filling out one application, a borrower can obtain anumber of alternative loan options from various Webservice companies. Borrowers can then select theoption that best suits their requirements.

Online mortgage firms, such as Lending Tree,have made mortgage lending more competitive. Thismay lead to lower rates and better service. It hasalso led lenders to offer an often confusing array ofloan alternatives that most borrowers have difficultyinterpreting. This makes comparison shopping moredifficult than simply comparing interest rates.

Borrowers using online services to shop for loansmust be aware that scam artists have found this aneasy way to obtain personal information. They set upa bogus loan site and offer extremely attractive inter-est rates to draw in customers. Once they have col-lected all the information needed to wipe out yourchecking, savings, and credit card accounts, theyclose their site and open another.


origination and servicing. They were also able to bundle loans from differentregions together, which helped reduce their risk. The increased competition forloans among these intermediaries led to lower rates for borrowers.

Securitization of MortgagesIntermediaries still faced several problems when trying to sell mortgages. The firstwas that mortgages are usually too small to be wholesale instruments. The averagenew home mortgage loan is now about $250,000. This is far below the $5 million roundlot established for commercial paper, for example. Many institutional investors do notwant to deal in such small denominations.

The second problem with selling mortgages in the secondary market was that theywere not standardized. They have different times to maturity, interest rates, andcontract terms. That makes it difficult to bundle a large number of mortgages together.

Third, mortgage loans are relatively costly to service. Compare the servicing amortgage loan requires to that of a corporate bond. The lender must collect monthlypayments, often pay property taxes and insurance premiums, and service reserveaccounts. None of this is required if a bond is purchased.

Finally, mortgages have unknown default risk. Investors in mortgages do not wantto spend a lot of time evaluating the credit of borrowers. These problems inspired thecreation of the mortgage-backed security, also known as a securitized mortgage.

What Is a Mortgage-Backed Security?By the late 1960s, the secondary market for mortgages was declining, mostly becausefewer veterans were obtaining guaranteed loans. The government reorganized FannieMae and also created two new agencies: the Government National Mortgage Association(GNMA, or Ginnie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC,or Freddie Mac). These three agencies were now able to offer new securities backedby both insured and, for the first time, uninsured mortgages.

An alternative to selling mortgages directly to investors is to create a new secu-rity backed by (secured by) a large number of mortgages assembled into what iscalled a mortgage pool. A trustee, such as a bank or a government agency, holdsthe mortgage pool, which serves as collateral for the new security. This process iscalled securitization. The most common type of mortgage-backed security is themortgage pass-through, a security that has the borrower’s mortgage payments passthrough the trustee before being disbursed to the investors in the mortgage pass-through. If borrowers prepay their loans, investors receive more principal thanexpected. For example, investors may buy mortgage-backed securities on whichthe average interest rate is 6%. If interest rates fall and borrowers refinance at lowerrates, the securities will pay off early. The possibility that mortgages will prepayand force investors to seek alternative investments, usually with lower returns, iscalled prepayment risk.

As is evident in Figure 14.3, the dollar volume of outstanding mortgage poolshas increased steadily since 1984. The reason that mortgage pools have becomeso popular is that they permit the creation of new securities (like mortgage pass-throughs) that make investing in mortgage loans much more efficient. For exam-ple, an institutional investor can invest in one large mortgage pass-throughsecured by a mortgage pool rather than investing in many small and dissimilarmortgage contracts.


Funds inMortgage Pools($ billions)

0

1,000

2,000

199519931991198919871985

3,000

4,000

5,000

6,000

8,000

7,000

19991997 2001 2003 2005 2007 2009

F I G U R E 1 4 . 3 Value of Mortgage Principal Held in Mortgage Pools, 1984–2010

Source: Federal Reserve Bulletin, various issues, Table 1.54, Line 55.

Types of Pass-Through SecuritiesThere are several types of mortgage pass-through securities: GNMA pass-throughs,FHLMC pass-throughs, and private pass-throughs.

Government National Mortgage Association (GNMA) Pass-Throughs GinnieMae began guaranteeing pass-through securities in 1968. Since then, the popular-ity of these instruments has increased dramatically.

A variety of financial intermediaries, including commercial banks and mortgagecompanies, originate Ginnie Mae mortgages. Ginnie Mae aggregates these mortgagesinto a pool and issues pass-through securities that are collateralized by the interestand principal payments from the mortgages. Ginnie Mae also guarantees the pass-through securities against default. The usual minimum denomination for pass-throughs is $25,000. The minimum pool size is $1 million. One pool may back up manypass-through securities.


Federal Home Loan Mortgage Corporation (FHLMC) Pass-Throughs FreddieMac was created to assist savings and loan associations, which are not eligible to orig-inate Ginnie Mae–guaranteed loans. Freddie Mac purchases mortgages for its ownaccount and also issues pass-through securities similar to those issued by Ginnie Mae.Pass-through securities issued by Freddie Mac are called participation certificates

(PCs). Freddie Mac pools are distinct from Ginnie Mae pools in that they contain con-ventional (nonguaranteed) mortgages, are not federally insured, contain mortgageswith different rates, are larger (ranging up to several hundred million dollars), andhave a minimum denomination of $100,000.

One innovation in the FHLMC pass-through market has been the collateralized

mortgage obligation (CMO). CMOs are securities classified by when prepaymentis likely to occur. These differ from traditional mortgage-backed securities in that theyare offered in different maturity groups. These securities help reduce prepaymentrisk, which is a problem with other types of pass-through securities.

CMOs backed by a particular mortgage pool are divided into tranches (Frenchfor “slices”). When principal is repaid, the investors in the first tranche are paidfirst, then those in the second tranche, and so on. Investors choose a tranche thatmatches their maturity requirements. For example, if they will need cash from theirinvestment in a few years, they purchase tranche 1 or 2 CMOs. If they want the invest-ment to be long-term, they can purchase CMOs from the last tranche.

Even when an investor purchases a CMO, there are no guarantees about how longthe investment will last. If interest rates fall significantly, many borrowers will pay offtheir mortgages early by refinancing at lower rates.

Real estate mortgage investment conduits (REMICs) were authorized by the1986 Tax Reform Act to allow originators to pass through all interest payments taxfree. Only their legal and tax consequences distinguish REMICs from CMOs.

Private Pass-Throughs (PIPs) In addition to the agency pass-throughs, interme-diaries in the private sector have offered privately issued pass-through securities. Thefirst of these PIPs was offered by BankAmerica in 1977.

One mortgage market opportunity available to private institutions is for mort-gages larger than the maximum size set by the government. These so-called jumbo

mortgages are often bundled into pools to back private pass-throughs.

Subprime Mortgages and CDOsSubprime loans are those made to borrowers who do not qualify for loans at theusual market rate of interest because of a poor credit rating or because the loan islarger than justified by their income. There can be subprime car loans or credit cards,but subprime mortgages have been highly publicized recently due to the high defaultrates realized when real estate values began dropping in 2006.

Before the securitized market made it easy to bundle and sell mortgages, if youdid not meet the qualifications for one of the major mortgage agencies, you wereunlikely to be able to buy a house. These qualifications were strictly enforced, andeach element was verified to assure compliance. Once it became possible to sellbundles of loans to other investors, different lending rules emerged. These new rulesgave rise to a new class of mortgage loans known as subprime mortgages.

According to the Mortgage Bankers Association, in 2000 about 70% of all loanswere conventional prime, 20% were FHA, 8% were VA, and only 2% were subprime.In 2006, 70% were still conventional prime, but now fully 17% were subprime, with

Access the homepage ofMBSCC, www.ficc.com, toget information on thisprovider of automatedpost-trade comparison,netting, risk management,and pool-notificationservices to the mortgage-backed securities market.

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the balance being FHA and VA. The FICO score is computed for virtually every bor-rower. This score is computed by the different credit rating agencies as an index ofcredit risk. Though each agency uses a slightly different algorithm, all include pay-ment history, level of current debt, length of credit history, types of credit held, andthe number of new credit inquiries made as criteria for rating credit worthiness.The average subprime FICO score was 624 versus 742 for prime mortgage loans.

Several innovative lending practices have led to this increase in lending to lesscredit worthy borrowers. First, 2/28 ARMs (sometimes called “teaser” loans) becamepopular. These loans freeze the interest rate for 2 years, and then it increases, oftensubstantially, after that. Piggyback loans, NoDoc, or NINJA (no income no asset loans),and variations on the graduated payment mortgage, as discussed in the last section,encouraged borrowers to commit to larger loans than they could realistically handle.

Many saw the increase in mortgage loans to less credit worthy borrowers asprogress. If home ownership is the goal of every American, then relaxed lending stan-dards allowed more families to reach their goal. The downside was that the com-petitive nature of the market led mortgage sales people to target less financiallysophisticated borrowers who were less able to properly evaluate their ability to repaythe loans. Additionally, the relaxed lending standards allowed speculators to obtainloans without investing any equity.

The growth of the subprime mortgage was in part fueled by the creation of thestructured credit products such as the collateralized debt obligation (CDO). Thesesecurities were first introduced in Chapter 8 as providing a source of funds for highrisk investments. A CDO is similar to the CMO discussed above, except that ratherthan slicing the pool of securities by maturity as with the CMO, the CDO usuallycreates tranches based on risk class. While CDOs can be backed by corporate bonds,REIT debt, or other assets, mortgage-backed securities are common.

When real estate values were rapidly increasing, borrowers could easily sell theirproperty if they found themselves unable to make the payments. Once the real estatemarket cooled in 2006 and 2007, it became much more difficult to sell property andmany borrowers were forced into default and bankruptcy. As discussed more fullyin Chapter 8, subprime lending was ultimately a leading cause of the financial crisisof 2007–2008 and led to a global recession.

The Real Estate BubbleThe mortgage market was heavily influenced by the real estate boom and bustbetween the years 2000 and 2008. Between 2000 and 2005 home prices increasedan average of 8% per year. They increased 17% in 2005 alone. The run-up in priceswas cause by two factors. The first was the increase in subprime loans discussed pre-viously. With more people now qualifying for loans, there was increased demand. Notethat by 2004 subprime lending made up 17% of all new loans. This meant that overa very short period many new buyers were now qualified to purchase homes. Whilehome construction increased, it could not keep pace with demand.

Real estate speculators were a second driver of the price bubble. People of allwalks of life started noticing that quick and apparently easy money was to be madeby buying real estate for the purpose of resale. The ability to obtain zero down loansallowed them to buy property easily and with little committed capital. They couldthen resell the property at a higher price. Many development projects were soldout before they were even started. The buyers were often speculators with no inten-tion of occupying the property. Condominiums were especially popular since they did


not require much upkeep by the owner until the next sale could be arranged. Attimes, speculators were selling to other speculators as the demand drove up prices.

As with most speculative bubbles, at some point the process ends. Default rates onthe subprime mortgages increased and the extent of speculation started to make thenews. Those left owning properties bought at the height of the market suffered losses,including lending institutions and investors in the mortgage-backed securities.

In the aftermath of a mortgage-fueled financial meltdown, lending policies havelargely returned to selecting capable borrowers. One indication of this is the declinein global CDO issuance. It peaked at $520 billion in 2006. By 2008 it had fallen to $62.9 billion. In 2009 it was $4.2 billion.

The securitized mortgage was initially hailed as a method for reducing the riskto lenders by allowing them to sell off a portion of their loan portfolio. The lendercould continue making loans without having to retain the risk. Unfortunately, this ledto increased moral hazard. By separating the lender from the risk, riskier loans wereissued than had the securitized mortgage channel not existed. Individual firm riskmay have been reduced, but systemic risk greatly increased.

S U M M A R Y

1. Mortgages are long-term loans secured by real estate.Both individuals and businesses obtain mortgageloans to finance real estate purchases.

2. Mortgage interest rates are relatively low due to com-petition among various institutions that want to makemortgage loans. In addition to keeping interest rateslow, the competition has resulted in a variety of termsand options for mortgage loans. For example, bor-rowers may choose to obtain a 30-year fixed-rate loanor an adjustable-rate loan that has its interest ratetied to the Treasury bill rate.

3. Several features of mortgage loans are designed toreduce the likelihood that the borrower will default.For example, a down payment is usually required sothat the borrower will suffer a loss if the lender repos-sesses the property. Most lenders also require that theborrower purchase private mortgage insurance unlessthe loan-to-value ratio drops below 80%.

4. A variety of mortgages are available to meet the needsof most borrowers. The graduated-payment mortgagehas low initial payments that increase over time. The

growing-equity mortgage has increasing paymentsthat cause the loan to be paid off in a shorter periodthan a level-payment loan. Shared-appreciation loanswere used when interest rates and inflation were high.The lender shared in the increase in the real estate’svalue in exchange for lower interest rates.

5. Securitized mortgages have been growing in popu-larity in recent years as institutional investors look forattractive investment opportunities. Securitized mort-gages are securities collateralized by a pool of mort-gages. The payments on the pool are passed throughto the investors. Ginnie Mae, Freddie Mac, and privatebanks issue pass-through securities. Securitized mort-gage securities separate the lending risk from thelender and lead to increasing risky loans.

6. Subprime loans increased in volume from being a neg-ligible portion of the mortgage loan volume in the1990s to 17% by 2006. Zero-down loans along withunderqualified borrows led speculative growth inhome prices and a subsequent collapse when defaultrates and lack of real demand became public.

K E Y T E R M S

amortized, p. 324

balloon loan, p. 324

collateralized mortgage obligation(CMO), p. 338

conventional mortgages, p. 330

discount points, p. 325

down payment, p. 328

FICO scores, p. 329

insured mortgages, p. 330

lien, p. 327

mortgage, p. 324

mortgage-backed security, p. 336

mortgage pass-through, p. 336

private mortgage insurance (PMI), p. 328

reserve accounts, p. 334

securitized mortgages, p. 336

subprime loans, p. 338


Q U E S T I O N S

1. What distinguishes the mortgage markets from othercapital markets?

2. Most mortgage loans once had balloon payments; nowmost current mortgage loans fully amortize. What isthe difference between a balloon loan and an amor-tizing loan?

3. What features contribute to keeping long-term mort-gage interest rates low?

4. What are discount points, and why do some mortgageborrowers choose to pay them?

5. What is a lien, and when is it used in mortgage lending?

6. What is the purpose of requiring that a borrowermake a down payment before receiving a loan?

7. What kind of insurance do lenders usually require of borrowers who have less than an 80% loan-to-value ratio?

8. Lenders tend not to be as flexible about the qualifi-cations required of mortgage customers as they canbe for other types of bank loans. Why is this so?

9. Distinguish between conventional mortgage loans andinsured mortgage loans.

10. Interpret what is meant when a lender quotes theterms on a loan as “floating with the T-bill plus 2 withcaps of 2 and 6.”

11. The monthly payments on both graduated-paymentloans and growing-equity loans increase over time.Despite this similarity, the two types of loans have dif-ferent purposes. What is the motivation behind eachtype of loan?

12. Many banks offer lines of credit that are secured bya second mortgage (or lien) on real property. Theseloans have been very popular among bank customers.Why are homeowners so willing to pledge their homesas security for these lines of credit?

13. The reverse annuity mortgage (RAM) allows retiredpeople to live off the equity they have in theirhomes without having to sell the home. Explain howa RAM works.

14. What is a securitized mortgage?

15. Describe how a mortgage pass-through works.

Q U A N T I TAT I V E P R O B L E M S

1. Compute the required monthly payment on an$80,000 30-year fixed-rate mortgage with a nominalinterest rate of 5.80%. How much of the payment goestoward principal and interest during the first year?

2. Compute the face value of a 30-year fixed-rate mort-gage with a monthly payment of $1,100, assuming anominal interest rate of 9%. If the mortgage requires5% down, what is the maximum house price?

3. Consider a 30-year fixed-rate mortgage for $100,000at a nominal rate of 9%. If the borrower wants to payoff the remaining balance on the mortgage after mak-ing the 12th payment, what is the remaining balanceon the mortgage?

4. Consider a 30-year fixed-rate mortgage for $100,000at a nominal rate of 9%. If the borrower pays an addi-tional $100 with each payment, how fast will the mort-gage be paid off?

5. Consider a 30-year fixed-rate mortgage for $100,000at a nominal rate of 9%. An S&L issues this mortgageon April 1 and retains the mortgage in its portfolio.However, by April 2 mortgage rates have increased toa 9.5% nominal rate. By how much has the value ofthe mortgage fallen?

6. Consider a 30-year fixed-rate mortgage of $100,000 ata nominal rate of 9%. What is the duration of the loan?If interest rates increase to 9.5% immediately afterthe mortgage is made, how much is the loan worthto the lender?

7. Consider a 5-year balloon loan for $100,000. The bankrequires a monthly payment equal to that of a 30-yearfixed-rate loan with a nominal annual rate of 5.5%.How much will the borrower owe when the balloonpayment is due?

8. A 30-year variable-rate mortgage offers a first-yearteaser rate of 2%. After that, the rate starts at 4.5%,adjusted based on actual interest rates. The maxi-mum rate over the life of the loan is 10.5%, and therate can increase by no more than 200 basis points ayear. If the mortgage is for $250,000, what is themonthly payment during the first year? Second year?What is the maximum payment during the fourthyear? What is the maximum payment ever?

9. Consider a 30-year fixed-rate mortgage for $500,000at a nominal rate of 6%. What is the difference inrequired payments between a monthly payment and abimonthly payment (payments made twice a month)?


(1) (2) (3) (4) (5) (6) (7)

Month

Beginning

Balance

Required

Payment Interest Principal

Expected

Prepayment

Servicing

Fees

Ending

Balance

1 100,000,000 500,000 99,551 16,665

2 33,322 99,750,430

10. Consider the following options available to a mort-gage borrower:

10% is annual inflation. Under the terms of the SAM,a 15-year mortgage is offered at 5%. After 15 years,the house must be sold, and the bank retains $400,000of the sale price. If inflation remains at 10%, what arethe cash flows to the bank? To the owner?

16. Consider a 30-year graduated-payment mortgage ona $250,000 mortgage with yearly payments. Thestated interest rate on the mortgage is 6%, but thefirst annual payment is calculated assuming a 3% ratefor the life of the loan. Thereafter, the annual pay-ment will grow by 3.151222%. Develop an amortiza-tion table for this loan, assuming the initial paymentis based on 30 years and the loan pays off in 15.

17. Consider a growing equity mortgage on a $250,000mortgage with yearly payments. The stated interestrate on the mortgage is 6%, but this only applies tothe first annual payment. Thereafter, the annual pay-ment will grow by 5.5797%. Develop an amortizationtable for this loan, assuming the initial payment isbased on 30 years and the loan pays off in 15 years.

18. Rusty Nail owns his house free and clear, and it’sworth $400,000. To finance his retirement, heacquires a reverse annuity mortgage (RAM) from hisbank. The RAM provides a fixed monthly paymentover 15 years on 70% of the value of his home at 5%.The payments are made at the beginning of themonth. How much does Rusty get each month?

19. You are working with a pool of 1,000 mortgages. Eachmortgage is for $100,000 and has a stated annualinterest rate (nominal) of 6.00%. The mortgages areall 30-year fixed rate and fully amortizing. Mortgageservicing fees are currently 0.25% annually. Completethe following table.

What is the effective annual rate for each option?

11. Two mortgage options are available: a 15-year fixed-rateloan at 6% with no discount points, and a 15-year fixed-rate loan at 5.75% with 1 discount point. Assuming youwill not pay off the loan early, which alternative is bestfor you? Assume a $100,000 mortgage.

12. Two mortgage options are available: a 30-year fixed-rate loan at 6% with no discount points, and a 30-yearfixed-rate loan at 5.75% with 1 discount point. Howlong do you have to stay in the house for the mort-gage with points to be a better option? Assume a$100,000 mortgage.

13. Two mortgage options are available: a 30-year fixed-rate loan at 6% with no discount points, and a 30-yearfixed-rate loan at 5.75% with points. If you are plan-ning on living in the house for 12 years, what is themost you are willing to pay in points for the 5.75%mortgage? Assume a $100,000 mortgage.

14. A mortgage on a house worth $350,000 requires whatdown payment to avoid PMI insurance?

15. Consider a shared-appreciation mortgage (SAM) on a$250,000 mortgage with yearly payments. Current mar-ket mortgage rates are high, running at 13%, of which

Loan

Amount

Interest

Rate

(%)

Type of

Mortgage

Discount

Points

Option 1 $100,000 6.75 30-year fixed none

Option 2 $150,000 6.25 30-year fixed 1

Option 3 $125,000 6.0 30-year fixed 2


W E B E X E R C I S E S

The Mortgage Markets1. You may be looking into acquiring a home in the near

future. One common question you may have is howlarge a mortgage loan you can afford. Go tohttp://interest.com and click on the “Mortgage” taband then on “calculators.” Choose the “mortgagerequired income calculator.” Input your expectedfuture salary data. How large a mortgage can youafford according to the calculator? Increase your debtto see the impact on the amount of mortgage loan youwill qualify for.

2. One of the more difficult decisions faced by home-owners is whether it pays to refinance a mortgage loanwhen rates have dropped. Go to http://interest.com

and click on the calculator labeled “Refinance interestsavings calculator.” Compute how long it will take torecoup the interest of refinancing your mortgage loan.Assume you obtained a 30-year $130,000 loan fouryears ago at 7%. Now rates have dropped and yourincome is higher. Determine how much you will saveif you get a new loan for 15 years at 6.25%.

http://interest.com

http://interest.com

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