A mortgage is a method of using property (real or personal) as security for the payment of a debt.
The term mortgage (from Law French, lit. death vow) refers to the legal device used in securing the property, but it is also commonly used to refer to the debt secured by the mortgage, the mortgage loan.
In most jurisdictions mortgages are strongly associated with loans secured on real estate rather than other property (such as ships) and in some cases only land may be mortgaged. Arranging a mortgage is seen as the standard method by which individuals or businesses can purchase residential or commercial real estate without the need to pay the full value immediately.
In many countries it is normal for home purchases to be funded by a mortgage. In countries where the demand for home ownership is highest, strong domestic markets have developed, notably in Spain, the United Kingdom and the United States.
In general terms the main participants in a mortgage are:
The creditor has legal rights to the debt secured by the mortgage and often makes a loan to the debtor of the purchase money for the property. Typically, creditors are banks, insurers or other financial institutions who make loans available for the purpose of real estate purchase.
A creditor is sometimes referred to as the mortgagee or lender.
The debtor[s] must meet the requirements of the mortgage conditions (and often the loan conditions) imposed by the creditor in order to avoid the creditor enacting provisions of the mortgage to recover the debt. Typically the debtors will be the individual home-owners, landlords or businesses who are purchasing their property by way of a loan.
A debtor is sometimes referred to as the mortgagor, borrower, or obligor.
Due to the complicated legal exchange, or conveyance, of the property, one or both of the main participants are likely to require legal representation. The terminology varies with legal jurisdiction; see lawyer, solicitor and conveyancer.
Because of the complex nature of many markets the debtor may approach a mortgage broker or financial adviser to help them source an appropriate creditor typically by finding the most competitive loan. Recently, many US consumers (particularly higher income borrowers) are choosing to work with Certified Mortgage Planners, industry experts that work closely with Certified Financial Planners to align the home finance position(s) of homeowners with their larger financial portfolio(s).
The debt is sometimes referred to as the hypothecation, which may make use of the services of a hypothecary to assist in the hypothecation.
In addition to borrowers, lenders, government sponsored agencies, private agencies; there is also a fifth class of participants who are the source of funds - the Life Insurers, Pension Funds, etc.
Like any other legal system, the mortgage business sometimes uses confusing jargon. Below are some terms explained in brief.
Advance is the money you have borrowed plus all the additional fees.
Base Rate In UK, this is the base interest rate set by the Bank of England. In the United States, this value is set by the Federal Reserve and is known as the Discount Rate.
Bridging Loan is a temporary loan that enables the borrower to purchase a new property before the borrower is able to sell another current property.
Conveyance is the legal document that transfers ownership of unregistered land.
Disbursements are all the fees of the solicitors and governments, such as stamp duty, land registry, search fees, etc.
Early Redemption Charge / Pre-Payment Penalty / Redemption Penalty is the amount of money due if the mortgage is paid in full before the time finished.
Equity is the market value of the property minus all loans outstanding on it.
First time buyer is the term given to a person buying property for the first time.
Freehold means the ownership of a property and the land.
Land Registration is a legal document that records the ownership of a property and land. This is also known as a Title.
Leasehold means the ownership of the property and land for a specified period, which may be sold separately from freehold, which may be owned by another person.
Legal Charge is a legal document that records the data of the rightful owner of a property or land.
Mortgage Deed is a legal document that stated that the lender has a legal charge over the property.
Mortgage Payment Protection Insurance is a form of insurance that ensures that the current mortgage payment will be paid if the borrower proves unable to do so.
Private Mortgage Insurance is a form of insurance the lender has the borrower take for loans over 80% of the appraised value. This will pay the lender only the owed portion up to 80% on a defaulted loan.
Sealing Fee is a fee made when the lender releases the legal charge over the property.
Subject To Contract is an agreement between seller and buyer before the actual contract is made.
There are essentially two types of legal mortgage:
Mortgage by demise
In a mortgage by demise, the creditor becomes the owner of the mortgaged property until the loan is repaid in full (known as "redemption"). This kind of mortgage takes the form of a conveyance of the property to the creditor, with a condition that the property will be returned on redemption.
This is an older form of legal mortgage and is less common than a mortgage by legal charge. It is no longer available in the UK, by virtue of the Land Registration Act 2002.
Mortgage by legal charge
In a mortgage by legal charge, the debtor remains the legal owner of the property, but the creditor gains sufficient rights over it to enable them to enforce their security, such as a right to take possession of the property or sell it.
To protect the lender, a mortgage by legal charge is usually recorded in a public register. Since mortgage debt is often the largest debt owed by the debtor, banks and other mortgage lenders run title searches of the real property to make certain that there are no mortgages already registered on the debtor's property which might have higher priority. Tax liens, in some cases, will come ahead of mortgages. For this reason, if a borrower has delinquent property taxes, the bank will often pay them to prevent the lienholder from foreclosing and wiping out the mortgage.
This type of mortgage is common in the United States and, since 1925, it has been the usual form of mortgage in England and Wales (it is now the only form - see above).
In Scotland, the mortgage by legal charge is also known as standard security.
At common law, a mortgage was a conveyance of land that on its face was absolute and conveyed a fee simple estate, but which was in fact conditional, and would be of no effect if certain conditions were not met --- usually, but not necessarily, the repayment of a debt to the original landowner. Hence the word "mortgage," Law French for "dead pledge;" that is, it was absolute in form, and unlike a "live gage", was not conditionally dependent on its repayment solely from raising and selling crops or livestock, or of simply giving the fruits of crops and livestock coming from the land that was mortgaged. The mortgage debt remained in effect whether or not the land could successfully produce enough income to repay the debt. In theory, a mortgage required no further steps to be taken by the creditor, such as acceptance of crops and livestock, for repayment.
The difficulty with this arrangement was that the lender was absolute owner of the property and could sell it, or refuse to reconvey it to the borrower, who was in a weak position. Increasingly the courts of equity began to protect the borrower's interests, so that a borrower came to have an absolute right to insist on reconveyance on redemption. This right of the borrower is known as the "equity of redemption".
This arrangement, whereby the mortgagee (the lender) was on theory the absolute owner, but in practice had few of the practical rights of ownership, was seen in many jurisdictions as being awkwardly artificial. By statute the common law position was altered so that the mortgagor would retain ownership, but the mortgagee's rights, such as foreclosure, the power of sale and the right to take possession would be protected.
In the United States, those states that have reformed the nature of mortgages in this way are known as lien states. A similar effect was achieved in England and Wales by the Law of Property Act 1925, which abolished mortgages by the conveyance of a fee simple.
Foreclosure and non-recourse lending
In most jurisdictions, a lender may foreclose the mortgaged property if certain conditions - principally, non-payment of the mortgage loan - obtain. Subject to local legal requirements, the property may then be sold. Any amounts received from the sale (net of costs) are applied to the original debt. In some jurisdictions, mortgage loans are non-recourse loans: if the funds recouped from sale of the mortgaged property are insufficient to cover the outstanding debt, the lender may not have recourse to the borrower after foreclosure. In other jurisdictions, the borrower remains responsible for any remaining debt. In virtually all jurisdictions, specific procedures for foreclosure and sale of the mortgaged property apply, and may be tightly regulated by the relevant government; in some jurisdictions, foreclosure and sale can occur quite rapidly, while in others, foreclosure may take many months or even years. In many countries, the ability of lenders to foreclose is extremely limited, and mortgage market development has been notably slower.
Types of Mortgage Instruments
Two types of mortgage instruments are used in the United States: the mortgage (sometimes called a mortgage deed) and the deed of trust.
In all but a few states, a mortgage creates a lien on the title to the mortgaged property. Foreclosure of that lien almost always requires a judicial proceeding declaring the debt to be due and in default and ordering a sale of the property to pay the debt.
The deed of trust
The deed of trust is a deed by the borrower to a trustee for the purposes of securing a debt. In most states, it also merely creates a lien on the title and not a title transfer, regardless of its terms. It differs from a mortgage in that, in many states, it can be foreclosed by a non-judicial sale held by the trustee. It is also possible to foreclose them through a judicial proceeding.
Most "mortgages" in California are actually deeds of trust. The effective difference is that the foreclosure process can be much faster for a deed of trust than for a mortgage, on the order of 3 months rather than a year.
Deeds of trust to secure repayments of debts should not be confused with deeds to trustees to create trusts for other purposes, such as estate planning. Though there are superficial similarities in the form, many states hold deeds of trust to secure repayment of debts do not create true trust arrangements.
What is a "Freddie Mac"?
Federal Home Loan Mortgage Corporation
The Federal Home Loan Mortgage Corporation ("Freddie Mac") NYSE: FRE, a government sponsored enterprise, is a stockholder-owned, publicly-traded company chartered by the United States federal government in 1970 to purchase mortgages and related securities, and then issue securities and bonds in financial markets backed by those mortgages in secondary markets. Freddie Mac, like its competitor Fannie Mae, is regulated by the Office of Federal Housing Enterprise Oversight (OFHEO) in the United States Department of Housing and Urban Development.
Freddie Mac's primary method for making money is by charging a guarantee fee which is usually a small part of the interest payment of the loans they have securitized into bonds. (For example, Freddie Mac may purchase a loan with a rate of 5.19 percent and put it into a mortgage backed security (MBS) bond which has a 5.0 percent coupon, keeping 0.19 percent as the guarantee fee.) Investors, or purchasers of Freddie Mac MBS, are willing to let Freddie Mac keep this fee in exchange for assuming the credit risk, that is, Freddie's guarantee that the principal of the underlying loan will be paid back regardless of whether the borrower actually repays. This is how Freddie Mac began making money at its inception and continues to do so today. But today, the majority of Freddie Mac's income is derived from the interest rate difference in the corporate debt Freddie Mac issues and the MBS that Freddie Mac's retained portfolio purchases
What is a "Fannie Mae"?
Federal National Mortgage Association
The Federal National Mortgage Association (FNMA; NYSE: FNM), commonly known as Fannie Mae, is a corporation sponsored by the United States Government. Created in 1938 to establish a secondary market for mortgages insured by the Federal Housing Administration (FHA). Along with other government sponsored enterprises (GSEs), Fannie Mae buys mortgages on the secondary market, pools them and sells them as mortgage-backed securities to investors on the open market. This secondary mortgage market helps to replenish the supply of lendable money for mortgages and ensures that money continues to be available for new home purchases. The name "Fannie Mae" is a creative acronym-portmanteau of the company's full name that has been adopted officially for ease of identification (see "Companies" below for other examples).
In 1968, the Federal National Mortgage Association was partitioned into two separate entities—one wholly owned by the government and known as the Government National Mortgage Association (Ginnie Mae), and the other to retain the name Federal National Mortgage Association (Fannie Mae). At this time, Fannie Mae expanded its charter to buying other sorts of mortgages besides the government-insured ones it had traditionally purchased. Fannie Mae became fully private in 1970 and is now the 9th largest business in the world according to Forbes' Rich List of top 1000 Businesses.
Fannie Mae is a consistently profitable corporation. While it receives no direct government funding or backing, it has certain looser restrictions placed on its activities than normal financial institutions. For example, it is allowed to sell mortgage backed securities with half the capital backing them up than is required by other financial institutions. Critics, including Alan Greenspan, say that this is only allowed because investors seem to think that there is a hidden, or implied, guarantee to the bonds that Fannie Mae sells . Although the company describes them as having no guarantee, nevertheless the vast majority of investors believe that the Government would prevent them from defaulting on their debt, and so buy bonds at very low interest rates as compared to others having like risk.
The second largest mortgage originator in the United States is Countrywide Financial, which is an almost exclusive Fannie Mae partner, although they have sold small amounts to some of the other GSEs. Countrywide's "loan production" during 2003 was $434.9 billion, of which most was sold to Fannie Mae.
While private mortgage originators can securitize and sell the mortgages (bundled together as a type of bond) themselves, GSEs like Fannie Mae can borrow money from private investors at lower rates, and have a record of packaging and selling mortgages with greater success.
Because of its stake in the mortgage market and because of its history, Fannie Mae (along with Freddie Mac) sets the limit each year on the size of a conforming loan based on the October to October changes in mean home price, above which a mortgage is considered a jumbo loan, and has higher rates associated with it. This is because both Fannie Mae and Freddie Mac only buy loans that are conforming, to repackage into the secondary market, making the demand for non-conforming loans much less. By virtue of the laws of supply and demand, then, it is harder for lenders to sell the loans, thus it would cost more to the consumers (typically 1/4 to 1/2 of a percent.) The conforming loan limit is 50 percent higher in Alaska, Hawaii, Guam and the US Virgin Islands.
What is a "Ginnie Mae"?
Government National Mortgage Association
The Government National Mortgage Association (GNMA, also known as "Ginnie Mae") was created by the United States Federal Government through a 1968 partition of the Federal National Mortgage Association. The GNMA is a wholly owned corporation within the United States' Department of Housing and Urban Development (HUD). Its main purpose is to provide financial assistance to low- to moderate-income homebuyers, by promoting mortgage credit.
The GNMA, along with the other so-called government sponsored enterprises (GSEs), sell mortgages in the secondary market. This lets investors put money in the mortgage securities market, which increases the price of the mortgage bonds and lowers their rates, which in turn lowers the rates on mortgages in the primary market so that more people are able to buy and mortgage a home. The GNMA does this by guaranteeing the timely payment of the principal and interest payments on mortgage-backed securities.
There are several types of GNMA securities that are active in the institutional fixed income markets:
Pools are created by lenders. For example, a mortgage lender may sign up 100 home mortgages in which each buyer agreed to pay a fixed interest rate of 6% for a 30-year term. The lender (who must be an approved issuer of GNMA certificates) obtains a guarantee from the GNMA and then sells the entire pool of mortgages to a bond dealer in the form of a "GNMA certificate". The bond dealer then sells GNMA mortgage-backed securities, paying 5.5% in this case, and backed by these mortgages, to investors. The original lender continues to collect payments from the home buyers, and forwards the money to a paying agent who pays the holders of the bonds. As these payments come in, the paying agent pays the principal which the home owners pay (or the amount that they are scheduled to pay, if some home owners fail to make the scheduled payment), and the 5.5% bond coupon payments to the investors. The difference between the 6% interest rate paid by the home owner and the 5.5% interest rate received by the investors consists of two components. Part of it is a guarantee fee (which GNMA gets) and part is a "servicing" fee, meaning a fee for collecting the monthly payments and dealing with the homeowner. If a home buyer defaults on payments, GNMA pays the bond coupon, as well as the scheduled principal payment each month, until the property is foreclosed. If (as is often the case) there is a shortfall (meaning a loss) after a foreclosure, GNMA still makes a full payment to the investor. If a home buyer prematurely pays off all or part of his loan, that portion of the bond is retired, or "called", the investor is paid accordingly, and no longer earns interest on that proportion of his bond.
The arrangement seemingly benefits everyone involved:
GNMA bonds themselves are considered risk-free from the standpoint of total default, but they are subject to risks that all other bonds have, including interest rate risk. They also have the undesirable attribute of being callable every month, meaning that, unlike other bonds, all or part of a GNMA bond might suddenly "mature" next month, if all the homeowners decided to pay off or refinance their mortgages. This does not involve a risk of loss to the investor, but rather a premature payment of the principal, and now the investor has to go look for another investment for his money. This is called prepayment risk. As a practical matter, many institutional investors find it very inconvenient to own bonds which get small principal payments every month.
The GNMA said in its 2003 annual report that over its history, it had guaranteed securities on the mortgages for over 30 million homes totaling over $2 trillion. It guaranteed $215.8 billion in these securities for the purchase or refinance of 2.4 million homes in 2003.
Adjustable Rate Mortgage
An adjustable rate mortgage, variable rate mortgage or floating rate mortgage is a mortgage loan where the interest rate on the note is periodically adjusted based on an index. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change). This is not to be confused with the graduated payment mortgage, which offers changing payment amounts but a fixed interest rate. Other forms of mortgage loan include interest only mortgage, fixed rate mortgage, negative amortization mortgage, discounted rate mortgage and balloon payment mortgage. Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls and loses out if interest rates rise.
Adjustable rate mortgages are characterized by their index and limitations on charges (caps). In many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages.
All adjustable rate mortgages have an adjusting interest rate tied to an index. Five common indices in the United States are:
In some countries, banks may publish a prime lending rate which is used as the index. The index may be applied in one of three ways: directly, on a rate plus margin basis, or based on index movement.
A directly applied index means that the interest rate changes exactly with the index. In other words, the interest rate on the note exactly equals the index. Of the above indices, only the contract rate index is applied directly.
To apply an index on a rate plus margin basis means that the interest rate will equal the underlying index plus a margin. The margin is specified in the note and remains fixed over the life of the loan. For example, a mortgage interest rate may be specified in the note as being LIBOR plus 2%, 2% being the margin and LIBOR being the index.
The final way to apply an index is on a movement basis. In this scheme, the mortgage is originated at an agreed upon rate, then adjusted based on the movement of the index. Unlike direct or index plus margin, the initial rate is not tied to any index; only the adjustments are tied to an index.
Limitations on charges (caps)
Any mortgage where payments made by the borrower may increase over time brings with it the risk of financial hardship to the borrower. To limit this risk, limitations on charges--known as caps in the industry--are a common feature of adjustable rate mortgages. Caps typically apply to three characteristics of the mortgage:
For example, a given ARM might have the following types of caps:
Interest rate adjustment caps:
Mortgage payment adjustment caps:
Life of loan interest rate adjustment caps:
Caps on the periodic change in interest rate may be broken up into one limit on the first periodic change and a separate limit on subsequent periodic change, for example 5% on the initial adjustment and 2% on subsequent adjustments.
Another common cap is a limitation on the maximum monthly payment expressed in absolute rather than relative terms, for example $1000 a month.
ARMs which allow negative amortization may have a payment adjustment frequency which differs from the interest rate adjustment frequency. For example, the interest rate may be adjusted every six months, but the payment amount only once every 12 months.
Cap structure is sometimes expressed as initial adjustment cap / subsequent adjustment cap / life cap, for example 2/2/5 for a loan with a 2% cap on the inital adjustment, a 2% cap on subsequent adjustments, and a 5% cap on total interest rate adjustments. When only two values are given, this indicates that the initial change cap and periodic cap are the same. For example, a 2/2/5 cap structure may sometimes be written simply 2/5.
Reasons for ARMs
In many countries, banks or similar financial institutions are the primary originators of mortgages. For banks that are funded from customer deposits, the customer deposits will typically have much shorter terms than residential mortgages. If a bank were to offer large volumes of mortgages at fixed rates but to derive most of its funding from deposits (or other short-term sources of funds), the bank would have an asset-liability mismatch: in this case, it would be running the risk that the interest income from its mortgage portfolio would be less than it needed to pay its depositors. In the United States, some argue that the savings and loan crisis was in part caused by this problem, that the savings and loans companies had short-term deposits and long-term, fixed rate mortgages, and were caught when Paul Volcker raised interest rates in the early 1980s.
To avoid this risk, many mortgage originators will sell or securitize their mortgages. Banking regulators pay close attention to asset-liability mismatches to avoid such problems, and place tight restrictions on the amount of long-term fixed-rate mortgages that banks may hold (in relation to their other assets).
In this perspective, banks and other financial institutions offer adjustable rate mortgages because it reduces risk and matches their sources of funding.
ARM Variants Hybrid ARMs
A hybrid adjustable-rate mortgage (ARM) is one where the interest rate on the note is fixed for a period of time, then floats thereafter. The "hybrid" refers to the blend of fixed rate and adjustable rate characteristics found in hybrid ARMs. Hybrid ARMs are referred to by their initial fixed period and adjustment periods, for example 3/1 for an ARM with a 3-year fixed period and subsequent 1-year rate adjustment periods. The date that a hybrid ARM shifts from a fixed-rate payment schedule to an adjusting payment schedule is known as the reset date. After the reset date, a hybrid ARM floats at a margin over a specified index just like any ordinary ARM.
The popularity of hybrid ARMs has significantly increased in recent years. In 1998, the percentage of hybrids relative to 30-year fixed rate mortgages was less than 2%; within 6 years, this increased to 27.5%.
Like other adjustable-rate products, hybrid ARMs transfer some interest rate risk from the lender to the borrower, thus allowing the lender to offer a lower note rate.
An "option ARM" is a loan where the borrower has the option of making either a specified minimum payment, an interest-only payment, or a 15-year or 30-year fixed rate in a given month. The minimum payment is less than an interest-only payment and therefore results in negative amortization, while the full payment is the fully amortized share of interest and principal.
Option ARMs are popular because they are usually offered with a very low initial interest rate (a so-called "teaser rate") and a low minimum payment, which permits borrowers to qualify for a much larger loan than would otherwise be possible.
Option ARMs are best suited to people in fields with sporadic income, such as some self-employed people or those in a highly seasonal business. For example, someone who makes the majority of their income around the winter holiday season, but who earns minimal income during the following few months may wish to pay the full payment during their busy season, but drop back to the interest-only payment or the minimum during a period of reduced earnings. This gives greater flexibility to how the mortgage is played. With a fixed-payment loan, if they were unable to meet the payment during their lean season they would risk late fees or foreclosure.
The main risk of an Option ARM is "payment shock", when the negative amortization reaches a stated maximum, at which point the minimum payment will be raised to a level that amortizes the loan balance. Another risk, as with any loan with potential negative amortization, is that the increased loan balance will reduce or eliminate the borrower's equity in the financed property, or if the value of the property declines, make it impossible to sell the property for an amount that will repay the loan.
Loan caps provide payment protection against payment shock, and allow a measure of interest rate certainty to those who gamble with initial fixed rates on ARM loans. There are three types of Caps on a typical First Lien Adjustable Rate Mortgage or First Lien Hybrid Adjustable Rate Mortgage.
Initial Adjustment Rate Cap: The majority of loans have a higher cap for initial adjustments that's indexed to the initial fixed period. In other words, the longer the initial fixed term, the more the bank would like to potentially adjust your loan. Typically, this cap is 2-3% above the Start Rate on a loan with an initial fixed rate term of 3 years or lower and 5-6% above the Start Rate on a loan with an initial fixed rate term of 5 years or greater.
Rate Adjustment Cap: This is the maximum amount by which an Adjustable Rate Mortgage may increase on each successive adjustment. Similar to the initial cap, this cap is usually 1% above the Start Rate for loans with an initial fixed term of 3 years or greater and usually 2% above the Start Rate for loans that have an initial fixed term of 5 years or greater
Lifetime Cap: Most First Mortgage loans have a 5% or 6% Life Cap above the Start Rate (this ultimately varies by the lender and credit grade).
Industry Shorthand for ARM Caps
Inside the business caps are expressed most often by simply the 3 numbers involved that signify each cap. For example, a 5/1 Hybrid ARM may have a cap structure of 5/2/5 (5% initial cap, 2% adjustment cap and 5% lifetime cap) and insiders would call this a 5-2-5 cap. Alternately a 1 year arm might have a 1/1/6 cap (1% initial cap, 1% adjustment cap and 6% lifetime cap) known as a 1-1-6, or alternately expressed as a 1/6 cap (leaving out one digit signifies that the initial and adjustment caps are identical).
Negative amortization ARM caps
See the complete article for the type of ARM that Negative amortization loans are by nature. Higher risk products, such as First Lien Monthly Adjustable loans with Negative amortization and Home Equity Lines of Credit aka HELOC have different ways of structuring the Cap than a typical First Lien Mortgage. The typical First Lien Monthly Adjustable loans with Negative amortization loan has a life cap for the underlying rate (aka "Fully Indexed Rate") between 9.95% and 12% (maximum assessed interest rate) in today's market. Beware though, some of these loans have 14-16% ceilings, you have to ask . . . . The fully indexed rate is always listed on the statement, but borrowers are shielded from the full effect of rate increases by the minimum payment, until the loan is recast, which is when principal and interest payments are due that will fully amortize the loan at the fully indexed rate until repayment is complete (or the house is foreclosed upon, refinanced or sold, whichever comes first).
Home Equity Lines of Credit (HELOC)
Since HELOCs are intended by banks to primarily sit in second lien position, they normally are only capped by the maximum interest rate allowed by law in the state wherein they are issued. For example, Florida, has an 18% cap on interest rate charges. These loans are risky in the sense that to lenders, they are practically a credit card issued to the borrower, with minimal security in the event of default. They are risky to the borrower in the sense that they are mostly indexed to the Wall Street Journal Prime Rate, which is considered a Spot Index, or a financial indicator that is subject to immediate change (as are the loans based upon the Prime Rate). The risk to borrower being that a financial catastrophe causing the Fed to Raise rates dramatically (see 1980) would effect an immediate rise in obligation to the borrower, up to the capped rate.
Variable rate mortgages are the most common form of loan for house purchase in the United Kingdom and Canada but are unpopular in some other countries. Variable rate mortgages are very common in Australia and New Zealand. In some countries, true fixed-rate mortgages are not available except for shorter-term loans; in Canada, the longest term for which a mortgage rate can be fixed is typically no more than ten years, while mortgage maturities are commonly 25 years.
In many countries, it is not feasible for banks to borrow at fixed rates for very long terms; in these cases, the only feasible type of mortgage for banks to offer may be floating rate mortgages (barring some form of government intervention).
For those who plan to move within a relatively short period of time (three to seven years), they are attractive because they often include a lower, fixed rate of interest for the first three, five, or seven years of the loan, after which the interest rate fluctuates.
Floating rate mortgages are typically, but not always, less expensive than fixed-rate mortgages. Due to the inherent interest rate risk, long-term fixed rates will tend to be higher than short-term rates (which are the basis for variable-rate loans and mortgages). The difference in interest rates between short and long-term loans is known as the yield curve, which generally slopes upward (longer terms are more expensive). The opposite circumstance is known as an inverted yield curve and is relatively infrequent.
The fact that an adjustable rate mortgage has a lower interest rate today (for example), does not tell us what the future cost of borrowing will be (when rates change). If rates rise, the cost will be higher; if rates go down, the rate will be lower. In effect, the borrower has agreed to take the interest rate risk. Some studies have shown that on average, the majority of borrowers with variable rate mortgages save money in the long term; but they have also demonstrated that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the riskof potentially higher costs; whether the additional risk is appropriate for a particular borrower will depend on many factors.
Adjustable rate mortgages, like other types of mortgage, may offer the ability to repay principal (or capital) early without penalty. Early payments of part of the principal will reduce the total cost of the loan (total interest paid), and will shorten the amount of time needed to pay off the loan. Early payoff of the entire loan amount (refinancing) is often done when interest rates drop significantly.
Adjustable rate mortgages are sometimes sold to unsophisticated consumers who are unlikely to be able to repay the loan should interest rates rise. In the United States, extreme cases are characterized by the Consumer Federation of America as predatory loans. Protections against interest rate rises include (a) a possible initial period with a fixed rate (which gives the borrower a chance to increase his/her annual earnings before payments rise); (b) a maximum (cap) that interest rates can rise in any year (if there is a cap, it must be specified in the loan document); and (c) a maximum (cap) that interest rates can rise over the life of the mortgage (this also must be specified in the loan document).
What is Negative Amortization?
In finance, negative amortization, also known as NegAm, is an amortization method in which the borrower pays back less than the full amount of interest owed to the lender each month. The shorted amount is then added to the total amount owed to the lender. Such a practice would have to be agreed upon before shorting the payment so as to avoid default on payment. Also known as deferred interest or Graduated Payment Mortgage (GPM).
Negative amortization only occurs in loans in which the periodic payment does not cover the amount of interest due for that loan period. The result of this is that the loan balance (or principal) increases by the amount of the unpaid interest. The purpose of such a feature is to increase affordability, or add payment savings and payment flexibility to a loan.
A newer loan option has been introduced which allows for a 40 year loan term. This makes the minimum payment even lower than a comparable 30 year term.
All NegAM home loans eventually require full repayment of principal and interest according to the original term of the mortgage and note signed by the borrower. Most loans only allow NegAM to happen for no more than 5 years, and have terms to "Recast" (see below) the payment to a fully amortizing schedule if the borrower allows the principal balance to rise to a pre-specified amount.
This loan is written often in high cost areas, because the monthly mortgage payments will be lower than any other type of financing instrument.
Negative amortization loans can be high risk loans for inexperienced investors. These loans tend to be safer in a falling rate market and riskier in a rising rate market.
Start rates on negative amortization or minimum payment option loans can be as low as 1%. This is the payment rate, not the actual interest rate. The payment rate is used to calculate the minimum payment. Other minimum payment options include 1.95% or more.
Adjustable Rate Feature
NegAM loans today are mostly straight Adjustable Rate Mortgages (ARMs), meaning that they are fixed for a certain period and adjust every time that period has elapsed; e.g., One month fixed, adjusting every month. The NegAm loan, like all Adjustable Rate Mortgages, is tied to a specific financial index which is used to determine the interest rate based on the current index and the margin (the markup the lender charges). Most NegAm loans today are tied to the Monthly Treasury Average, in keeping with the monthly adjustments of this loan. There are also Hybrid ARM loans in which there is a period of fixed payments for months or years, followed by an increased change cycle, such as six months fixed, then monthly adjustable.
The Graduated Payment Mortgage is a "fixed rate" NegAm loan, but since the payment increases over time, it has aspects of the ARM loan until amortizing payments are required.
The most notable differences between the Traditional Payment Option Arm and the Hybrid Payment Option Arm are in the start rate also known as the "minimum payment" rate. On a Tradiitional Payment Option Arm the minimum payment is based on a principal and interest calculation of 1%-2.5% on average.
The start rate on a Hybrid Payment Option Arm are higher yet still extremely competitive payment wise.
On a Hybrid Payment Option Arm the minimum payment is derived using the "interest only" calculation of the start rate. The start rate on the Hybrid Payment Option arm typically is calculated by taking the Fully Indexed Rate (Actual Note Rate) then subtracting 3% which will give you that start rate.
Example: 7.5% fully indexed rate - 3% = 4.5% (4.5% would be the start rate on a Hybrid Pay Option Arm)
This guideline can vary between lenders.
Aliases the Payment Option Arm loans are known by:
NegAm - Mortgage Terminology
Cap - percentage rate of change in the NegAm payment. Each year, the minimum payment due rises. Most minimum payments today rise at 7.5%. Considering that raising a rate 1% on a mortgage at 5% is a 20% increase, the NegAm can grow quickly in a rising market. Typically after the 5th year, the loan is recast to an adjustable loan due in 25 years. This is for a 30 year loan term. Newer payment option loans often offer a 40 year term with a higher underlying interest rate. Watch Out for this if you want to preserve your equity!
Life Cap - the maximum interest rate allowed after recast according to the terms of the note. Generally most NegAm loans in the last 5 years have a life cap of 9.95%. Today many of these loans are capped at 12% or above! Watch out!
Payment Options - There are typically 4 payment options:
Period - how often the NegAm payment changes. Typically, the minimum payment rises once every twelve months in these types of loans. Usually the rate of rise is 7.5%
Recast - premature stop of NegAm. Should your negative balance reach a predetermined amount (typically 115% of the original balance, or 110% in New York)) your loan will be "recast" with one of two payment options: the fully amortized principal and interest payment, or if the maximum balance has been reached before the fifth year, an interest only payment until the loan has matured to the recast date. (typically 5 years)
Stop - end of NegAm payment schedule.
Criticisms of Negative Amortization loans
Negative Amortization loans, being relatively popular only in the last decade, have attracted a variety of criticisms.
Unlike most other adjustable rate loans, many negative amortization loans have been advertised with either teaser or artificially introductory interest rates or with the minimum loan payment expressed as a percentage of the loan amount. For example a negative amortization loan is often advertised as featuring "1% interest", or by prominently displaying a 1% number without explaining the real interest rate. This practice has been done by large corporate lenders such as Countrywide. This practice has been considered deceptive for two different reasons: most mortgages do not feature teaser rates so consumers do not look out for them, and many consumers aren't aware of the negative amortization side effect of only paying 1% of the loan amount per year. In addition, most negative amortization loans contain a clause saying that the payment may not increase more then 7.5% each year, except if the 5 year period is over or if the balance has grown 15%. Critics say this clause is only there to deceive borrowers into thinking the payment could only jump a small amount, whereas in fact the other two conditions are more likely to occur.
Negative amortization loans as a class have the highest potential for what is known as payment shock. Payment shock is when the required monthly payment jumps from one month to the next, potentially becoming unaffordable. To compare various mortgages payment shock potential:
Mortgage Life Insurance refers to a insurance policy that guarantees repayment of a mortgage loan in the event of death or, possibly, disability of the mortgagor. Private Mortgage Insurance or PMI refers to protection for the lender in the event of default, usually covering a portion of the amount borrowed. There are Government loan products that also include a Mortgage Insurance Premium or MIP.
For example, Mr. Smith obtains a mortgage loan that exceeds 80% of his property's value and/or sale price. Because of his limited equity, the lender requires that Mr. Smith pay for mortgage insurance that protects their institution against his default. To obtain a mortgage loan insured by the Federal Housing Administration, Mr. Smith must pay a mortgage insurance premium (MIP) equal to 1.5 percent of the loan amount at closing. This premium is normally financed by the lender and paid to FHA on the borrower's behalf. Depending on the loan-to-value ratio, there may be a monthly premium as well.
Types of Mortgage Insurance
Private Mortgage Insurance (PMI) is default insurance on mortgage loans, provided by private insurance companies. PMI allows borrowers to obtain a mortgage without having to provide 20% down payment, by covering the lender for the added risk of a high loan-to-value (LTV) mortgage. The Homeowners Protection Act of 1998 requires PMI to be canceled when the amount owed reaches a certain level, particularly when the loan balance is 78 percent of the home's purchase price. Often, PMI can be cancelled earlier by submitting a new appraisal showing that the loan balance is less than 80% of the home's value due to appreciation (this generally requires two years of on-time payments first) Different terms: Mortgagee's Title Insurance is a policy that protects the lender from future claims to ownership of the mortgaged property. Generally required by the lender as a condition of making a mortgage. In the event of a successful ownership claim from someone other than the mortgagor, the insurance company compensates the lender for any consequent losses. Mortgagor's Title Insurance is a policy protecting the buyer/ owner of real property from successful claims of ownership interest to the property. The coverage usually is supplemental to a Mortgagee's Title Insurance policy, and the premium is customarily paid by the buyer.