Types of Mortgage Loans

Types of mortgage loans	Key features	Mortgagors	Advantages	Disadvantages
Insured Mortgages 1
Conventional Mortgages2
Fixed-Rate Mortgages3
Adjustable-Rate Mortgages4
Graduated-Payment Mortgages5
Growing-Equity Mortgages6
Shared-Appreciation Mortgages7
Equity Participation Mortgages8
Second Mortgages9
Reverse Annuity Mortgages10

1. Insured Mortgage-

2. Conventional Mortgage-

3. Fixed-Rate Mortgage-

4. Adjustable-Rate Mortgage-

5. Graduated-Payment Mortgage-

6. Growing-Equity Mortgage-

7. Shared-Appreciation Mortgage-

8. Equity Participation Mortgage-

9. Second Mortgage-

10. Reverse Annuity Mortgage-

Types of Mortgage loans

1. Insured and Conventional Mortgages

Mortgages are classified as either insured or conventional. Insured mortgages are originated by banks or other mortgage lenders but are guaranteed by some institutions e. g. in the USA either the Federal Housing Administration (FHA) or the Veterans Administration (VA). Applicants for FHA and VA loans must meet certain qualifications, such as hav­ing served in the military or having income below a given level, and can borrow only up to a certain amount. The FHA or VA then guarantees the bank making the loans against any losses - that is, the agency guarantees that it will pay off the mortgage loan if the borrower defaults. One important advantage to a borrower who qualifies for 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 loans but are not guaranteed. Private mortgage companies now insure many conventional loans against default. Most lenders require the borrower to obtain pri­vate mortgage insurance on all loans with a loan-to-value ratio exceeding 80%.

2. Fixed- and Adjustable-Rate Mortgages

In standard mortgage contracts, borrowers agree to make regular payments on the principal and interest they owe to lenders. The interest rate significantly affects the size of this monthly payment. Infixed-rate mortgages, the interest 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 mar­ket interest rate and therefore changes over time.

ARMs usually have limits, called caps, on how high (or low) the interest rate can move in one year and during the term of the loan. A typical ARM might tie the interest rate to the average Trea­sury bill rate plus 2%, with caps of 2% per year and 6% over the lifetime of the mortgage. Caps make ARMs more palatable to borrowers.

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

Lenders, by contrast, prefer ARMs because ARMs lessen interest-rate risk. The interest-rate risk is the risk that rising interest rates will cause the value of debt instruments to fall. The effect on the value of the debt is greatest when the 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 the sensitivity 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 on fixed-rate loans.

3. Graduated-Payment Mortgages (GPMs)

Graduated-Payment Mortgages (GPMs) Graduated-payment mortgages are use­ful for home buyers who expect their incomes to rise. The GPM has lower pay­ments in the first few years; then the payments rise. The early payments may not even be sufficient 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 payment will not be a burden.

The advantage of the GPM is that borrowers will qualify for a larger loan than if they requested a conventional mortgage. This may help buyers purchase ade­quate housing now and avoid the need to move to more expensive homes as their family size increases. The disadvantage is that the payments escalate whether the borrower’s income does or not.

4. Growing-Equity Mortgages (GEMs)

Growing-Equity Mortgages (GEMs) Lenders designed the growing-equity mort­gage loan to help the borrower pay off the loan in a shorter period of time. With a GEM, 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 more quickly than the conventional payment stream would. For example, a typical contract may call for level payments for the first two years. The payments may increase by 5% per year for the next five years, than remain the same until maturity. The result is to reduce the life of the loan from 30 years to about 17.

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

The GEM is similar to the graduated-payment mortgage; the difference is that the 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 borrower pay off early.

5. Shared-Appreciation Mortgages (SAMs) and Equity Participation Mortgages

Shared-Appreciation Mortgages (SAMs) When interest rates are high, the monthly payments on mortgage loans are also high. That prevents many borrowers from qualifying for loans. To help borrowers qualify and to keep loan volume high, lenders created the shared-appreciation mortgage. In a SAM, the lender lowers the interest rate on the mortgage in exchange for a share of any appreciation in the real estate (if the property sells for more than a stated amount, the lender is entitled to a portion of the gain). As interest rates and inflation fell in the late 1980s and into the 1990s, the popularity of these loans also diminished.

Equity Participation Mortgages In a shared-appreciation mortgage, the lender shares in the appreciation of the property. In an equity participation mortgage, an outside investor rather than the lender shares in the appreciation of the prop­erty. This investor will either provide a portion of the purchase price of the prop­erty or supplement the monthly payments. In return, the investor receives a portion of any appreciation in the property. As with the SAM, the borrower ben­efits by being able to qualify for a larger loan than without such help.

6. Second Mortgages

Second mortgages are loans that are secured by the same real estate that is used to secure the first mortgage. The second mortgage is junior to the original loan. This means that should a default occur, the second mort­gage holder wall be paid only after the original loan has been paid off, if sufficient funds remain.

Second mortgages have two purposes. The first is to give borrowers a way to use the equity they have in their homes as security for another loan. An alter­native to the second mortgage would be to refinance the home at a higher loan amount than is currently owed. The cost of obtaining a second mortgage is often much lower than refinancing.

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

7. Reverse Annuity Mortgages (RAMs)

The reverse annuity mortgage is an innova­tive method for retired people to live on the equity they have in their homes. The contract for a RAM has the bank advancing funds on a monthly schedule. This increasing-balance loan is secured by the real estate. The borrower does not make any payments against the loan. When the borrower dies, the borrower’s estate sells the property to retire the debt.

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

Exercise 12.Match the type of a mortgage loan with its definition.

1.	Conventional mortgage	a.	Initial low payment increases each year; loan amortizes in 30 years
2.	Insured mortgage	b.	Initial payment increases each year; loan amortizes in less than 30 years
3.	Adjustable-rate mortgage (ARM)	c.	Loan is secured by a second lien against the real estate; often used for lines of credit or home improvement loans
4.	Graduated-payment mortgage (GPM)	d.	In exchange for providing a Low interest rate, the lender shares in any appreciation of the real estate
5.	Growing-equity mortgage (GEM)	e.	Lender disburses a monthly payment to the borrower on an increasing-balance loan; loan comes due when the real estate is sold
6.	Shared-appreciation mortgage (SAM)	f.	Loan is not guaranteed; usually requires private mortgage insurance; 5% to 20% down payment
7.	Equity participation mortgage	g.	Interest rate is tied to some other security and is adjusted periodically; size of adjustment is subject to annual limits
8.	Second mortgage	h.	In exchange for paying a portion of the down payment or for supplementing the monthly payments, an outside investor shares in any appreciation of the real estate
9.	Reverse annuity mortgage	i.	Loan is guaranteed by FHA or VA; low or zero down payment

Exercise13. Role-play the situation.

One person is a mortgagor another is a loan officer.

The aim of a mortgagor is to obtain a loan needful for him\ her (state your requirements).

The aim of a loan officer is to suggest a mortgagor the most suitable for him\ her type of a mortgage loan.

Use the following phrases:

(Income below a given level, to pay off the mortgage loan, to obtain pri­vate mortgage insurance, down pay­ment, to make regular payments on the principal,

to change over time, the lifetime of the mortgage, to prefer fixed-rate loans,

financial hardship, to remain the same until maturity, prepayment penalty,

to keep loan volume high, the purchase price of the prop­erty, to meet living expenses).

Exercise 14.Complete the table with the information studied in this unit.

Types of mortgage markets
Mortgage market participants
Options that influence a mortgage loan
Options that influence a loan term
The inter­est rate on the loan is determined by three factors
Types of mortgage loans

Economic reasoning and discussion

1.What distinguishes the mortgage markets from other capital markets?

1. What features contribute to keeping long-term mortgage interest rates low?

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

3. What is the purpose of requiring that a borrower make a down payment before receiving a loan?

4. Lenders tend not to be as flexible about the qualifications required of mortgage customers as they can be for other types of bank loans. Why is this so?

5. The reverse annuity mortgage (RAM) allows retired people to live off the equity they have in their homes without having to sell the home. Explain how a RAM works.

6. Consider a 30-year fixed-rate mortgage for $100,000 at a nominal rate of 9%. If the borrower wants to pay off the remaining balance on the mortgage after making the 12th payment, what is the remaining balance on the mortgage?

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

8. Distinguish between conventional mortgage loans and insured mortgage loans.

9. Many banks offer lines of credit that are secured by a second mortgage (or lien) on real property. These loans have been very popular among bank customers. Why are homeowners so willing to pledge their homes as security for these lines of credit?

10. During the 2007 - 2009 recession, many people who had taken out mortgages to buy homes found that they were having trouble making the payments on their mortgage. Because housing prices were falling, many found that the amount they owed on their mortgage was greater than the price of their home. Significant number of people defaulted on their mortgages. The following appeared in an article discussing this issue in the Economist magazine: Since foreclosures are costly for lenders as well as painful for borrowers, both sides could be better off by renegotiating a mortgage. The sticking point, according to conventional wisdom, is securitization. When mortgages are sliced into numerous pieces it is far harder to get lenders to agree on changing their terms. Why might both lenders and borrowers be better off as a result of negotiating a mortgage? How does securitization result in mortgages being “sliced into numerous pieces”? Why would securitization make renegotiating a loan more difficult? How would theses difficulties effect the services that securitization provides to savers and borrowers? Source: Mortgage mistakes, Economist, July 9, 2009.