A
mortgage loan is a
loan
secured by
real property through the use of a
document which evidences the existence of the loan
and the
encumbrance of that realty
through the granting of a
mortgage which
secures the loan. However, the
word
mortgage alone, in everyday usage, is most often used
to mean
mortgage loan.
A home buyer or builder can obtain financing (a loan) either to
purchase or secure against the property from a financial
institution, such as a
bank, either directly or
indirectly through intermediaries. Features of mortgage loans such
as the size of the loan, maturity of the loan, interest rate,
method of paying off the loan, and other characteristics can vary
considerably.
In many
countries, though not all (Iran
and Bali, Indonesia
are two exceptions), it is normal for home
purchases to be funded by a mortgage loan. Few individuals
have enough savings or liquid funds to enable them to purchase
property outright. In countries where the demand for
home ownership is highest, strong domestic
markets have developed.
Mortgage loan basics
Basic concepts and legal regulation
According to Anglo-American
property
law, a mortgage occurs when an owner (usually of a
fee simple interest in
realty) pledges his interest (right to the
property) as
security or
collateral for a loan. Therefore, a
mortgage is an
encumbrance (limitation)
on the right to the property just as an
easement would be, but because most mortgages occur
as a condition for new loan money, the word
mortgage has
become the generic term for a
loan secured by
such
real property.
As with other types of loans, mortgages have an interest rate and
are scheduled to
amortize over a set
period of time, typically 30 years. All types of real property can,
and usually are, secured with a mortgage and bear an interest rate
that is supposed to reflect the lender's risk.
Mortgage lending is the primary mechanism used in many countries to
finance private ownership of residential and commercial property
(see
commercial mortgages).
Although the terminology and precise forms will differ from country
to country, the basic components tend to be similar:
- Property: the physical residence being financed. The exact form
of ownership will vary from country to country, and may restrict
the types of lending that are possible.
- Mortgage: the security interest of lender in the
property, which may entail restrictions on the use or disposal of
the property. Restrictions may include requirements to purchase
home insurance and mortgage insurance) or pay off
outstanding debt before selling the property.
- Borrower: the person borrowing who
either has or is creating an ownership interest in the
property.
- Lender: any lender, but usually a
bank or other financial institution. Lenders may
also be investors who own an interest in
the mortgage through a mortgage-backed security. In such a
situation, the initial lender is known as the mortgage originator,
which then packages and sells the loan to investors. The payments
from the borrower are thereafter collected by a loan servicer.
- Principal: the original size of the loan, which may or may not
include certain other costs; as any principal is repaid, the
principal will go down in size.
- Interest: a financial charge for use of
the lender's money.
- Foreclosure or repossession: the possibility that the lender
has to foreclose, repossess or seize the property under certain
circumstances is essential to a mortgage loan; without this aspect,
the loan is arguably no different from any other type of loan.
Many other specific characteristics are common to many markets, but
the above are the essential features. Governments usually regulate
many aspects of mortgage lending, either directly (through legal
requirements, for example) or indirectly (through regulation of the
participants or the financial markets, such as the banking
industry), and often through state intervention (direct lending by
the government, by state-owned banks, or sponsorship of various
entities). Other aspects that define a specific mortgage market may
be regional, historical, or driven by specific characteristics of
the legal or financial system.
Mortgage loans are generally structured as long-term loans, the
periodic payments for which are similar to an
annuity and calculated according to
the
time value of money
formulae. The most basic arrangement would require a fixed monthly
payment over a period of ten to thirty years, depending on local
conditions. Over this period the principal component of the loan
(the original loan) would be slowly paid down through
amortization. In practice, many variants are
possible and common worldwide and within each country.
Lenders provide funds against property to earn
interest income, and generally borrow these
funds themselves (for example, by taking
deposits or issuing
bonds). The price at which the lenders borrow
money therefore affects the cost of borrowing. Lenders may also, in
many countries, sell the mortgage loan to other parties who are
interested in receiving the stream of cash payments from the
borrower, often in the form of a security (by means of a
securitization). In the United States, the
largest firms securitizing loans are
Fannie
Mae and
Freddie Mac, which are
government sponsored enterprises.
Mortgage lending will also take into account the (perceived)
riskiness of the mortgage loan, that is, the likelihood that the
funds will be repaid (usually considered a function of the
creditworthiness of the borrower); that if they are not repaid, the
lender will be able to foreclose and recoup some or all of its
original capital; and the financial,
interest rate risk and time delays that
may be involved in certain circumstances.
Mortgage loan types
There are many types of mortgages used worldwide, but several
factors broadly define the characteristics of the mortgage. All of
these may be subject to local regulation and legal
requirements.
- Interest: interest may be fixed for the life of the loan or
variable, and change at certain pre-defined periods; the interest
rate can also, of course, be higher or lower.
- Term: mortgage loans generally have a maximum term, that is,
the number of years after which an amortizing loan will be repaid.
Some mortgage loans may have no amortization, or require full
repayment of any remaining balance at a certain date, or even
negative amortization.
- Payment amount and frequency: the amount paid per period and
the frequency of payments; in some cases, the amount paid per
period may change or the borrower may have the option to increase
or decrease the amount paid.
- Prepayment: some types of mortgages may limit or restrict
prepayment of all or a portion of the loan, or require payment of a
penalty to the lender for prepayment.
The two basic types of amortized loans are the
fixed rate mortgage (FRM) and
adjustable rate mortgage (ARM)
(also known as a
floating
rate or
variable rate
mortgage). In many countries, floating rate mortgages are the
norm and will simply be referred to as mortgages; in the United
States, fixed rate mortgages are typically considered "standard."
Combinations of fixed and floating rate are also common, whereby a
mortgage loan will have a fixed rate for some period, and vary
after the end of that period.
Historical U.S.
In a fixed rate mortgage, the interest rate, and hence periodic
payment, remains fixed for the life (or term) of the loan. In the
U.S., the term is usually up to 30 years (15 and 30 being the most
common), although longer terms may be offered in certain
circumstances. For a fixed rate mortgage, payments for principal
and interest should not change over the life of the loan, although
ancillary costs (such as property taxes and insurance) can and do
change.
In an adjustable rate mortgage, the interest rate is generally
fixed for a period of time, after which it will periodically (for
example, annually or monthly) adjust up or down to some market
index. Common indices in the U.S. include the
Prime rate, the
London Interbank Offered Rate
(LIBOR), and the Treasury Index ("T-Bill"); other indices are in
use but are less popular.You can select the mortgage loan you
require when interest rates are quite low and get it adjusted
throughout the loan term.
Adjustable rates transfer part of the interest rate risk from the
lender to the borrower, and thus are widely used where fixed rate
funding is difficult to obtain or prohibitively expensive. Since
the risk is transferred to the borrower, the initial interest rate
may be from 0.5% to 2% lower than the average 30-year fixed rate;
the size of the price differential will be related to debt market
conditions, including the
yield
curve.
Additionally, lenders in many markets rely on credit reports and
credit scores derived from them. The higher the score, the more
creditworthy the borrower is assumed to be. Favorable interest
rates are offered to buyers with high scores. Lower scores indicate
higher risk for the lender, and higher rates will generally be
charged to reflect the (expected) higher default rates.
A partial amortization or
balloon loan is one where the
amount of monthly payments due are calculated (amortized) over a
certain term, but the outstanding principal balance is due at some
point short of that term. This payment is sometimes referred to as
a "balloon payment" or
bullet
payment. The interest rate for a balloon loan can be either
fixed or floating. The most common way of describing a
balloon
loan uses the terminology X due in Y, where X is the number of
years over which the loan is amortized, and Y is the year in which
the principal balance is due.
Other loan types:
Loan to value and downpayments
Upon making a mortgage loan for purchase of a property, lenders
usually require that the borrower make a downpayment, that is,
contribute a portion of the cost of the property. This downpayment
may be expressed as a portion of the value of the property (see
below for a definition of this term). The loan to value ratio (or
LTV) is the size of the loan against the value of the property.
Therefore, a mortgage loan where the purchaser has made a
downpayment of 20% has a loan to value ratio of 80%. For loans made
against properties that the borrower already owns, the loan to
value ratio will be imputed against the estimated value of the
property.
The loan to value ratio is considered an important indicator of the
riskiness of a mortgage loan: the higher the LTV, the higher the
risk that the value of the property (in case of foreclosure) will
be insufficient to cover the remaining principal of the loan.
Value: appraised, estimated, and actual
Since the value of the property is an important factor in
understanding the risk of the loan, determining the value is a key
factor in mortgage lending. The value may be determined in various
ways, but the most common are:
- Actual or transaction value: this is usually taken to be the
purchase price of the property. If the property is not being
purchased at the time of borrowing, this information may not be
available.
- Appraised or surveyed value: in most jurisdictions, some form
of appraisal of the value by a licensed professional is common.
There is often a requirement for the lender to obtain an official
appraisal.
- Estimated value: lenders or other parties may use their own
internal estimates, particularly in jurisdictions where no official
appraisal procedure exists, but also in some other
circumstances.
Equity or homeowner's equity
The concept of equity in a property refers to the value of the
property minus the outstanding debt, subject to the definition of
the value of the property. Therefore, a borrower who owns a
property whose estimated value is $400,000 but with outstanding
mortgage loans of $300,000 is said to have homeowner's equity of
$100,000.
Payment and debt ratios
In most countries, a number of more or less standard measures of
creditworthiness may be used. Common measures include payment to
income (mortgage payments as a percentage of gross or net income);
debt to income (all debt
payments, including mortgage payments, as a percentage of income);
and various net worth measures. In many countries,
credit scores are used in lieu of or to
supplement these measures. There will also be requirements for
documentation of the creditworthiness, such as income tax returns,
pay stubs, etc; the specifics will vary from location to
location.
Some lenders may also require a potential borrower have one or more
months of "reserve assets" available. In other words, the borrower
may be required to show the availability of enough assets to pay
for the housing costs (including mortgage, taxes, etc.) for a
period of time in the event of the job loss or other loss of
income.
Many countries have lower requirements for certain borrowers, or
"no-doc" / "low-doc" lending standards that may be acceptable in
certain circumstances.
Standard or conforming mortgages
Many countries have a notion of standard or conforming mortgages
that define a perceived acceptable level of risk, which may be
formal or informal, and may be reinforced by laws, government
intervention, or market practice. For example, a standard mortgage
may be considered to be one with no more than 70-80% LTV and no
more than one-third of gross income going to mortgage debt.
A standard or conforming mortgage is a key concept as it often
defines whether or not the mortgage can be easily sold or
securitized, or, if non-standard, may affect the price at which it
may be sold. In the United States, a conforming mortgage is one
which meets the established rules and procedures of the two major
government-sponsored entities in the housing finance market
(including some legal requirements). In contrast, lenders who
decide to make nonconforming loans are exercising a higher risk
tolerance and do so knowing that they face more challenge in
reselling the loan. Many countries have similar concepts or
agencies that define what are "standard" mortgages. Regulated
lenders (such as banks) may be subject to limits or higher risk
weightings for non-standard mortgages. For example, banks in Canada
face restrictions on lending more than 75% of the property value;
beyond this level, mortgage insurance is generally required (as of
April 2007, there is a proposal to raise this limit to 80%).
Repaying the capital
There are various ways to repay a mortgage loan; repayment depends
on locality, tax laws and prevailing culture.
Capital and interest
The most common way to repay a loan is to make regular payments of
the capital (also called principal) and interest over a set term.
This is commonly referred to as (self)
amortization in the U.S.
and as a
repayment
mortgage in the UK. A mortgage is a form of
annuity (from the perspective of
the lender), and the calculation of the periodic payments is based
on the
time value of money
formulas. Certain details may be specific to different locations:
interest may be calculated on the basis of a 360-day year, for
example; interest may be
compounded daily, yearly, or
semi-annually;
prepayment
penalties may apply; and other factors. There may be legal
restrictions on certain matters, and
consumer protection laws may
specify or prohibit certain practices.
Depending on the size of the loan and the prevailing practice in
the country the term may be short (10 years) or long (50 years
plus). In the UK and U.S., 25 to 30 years is the usual maximum term
(although shorter periods, such as 15-year mortgage loans, are
common). Mortgage payments, which are typically made monthly,
contain a capital (repayment of the principal) and an interest
element. The amount of capital included in each payment varies
throughout the term of the mortgage. In the early years the
repayments are largely interest and a small part capital. Towards
the end of the mortgage the payments are mostly capital and a
smaller portion interest. In this way the payment amount determined
at outset is calculated to ensure the loan is repaid at a specified
date in the future. This gives borrowers assurance that by
maintaining repayment the loan will be cleared at a specified date,
if the interest rate does not change.
Interest only
The main alternative to capital and interest mortgage is an
interest only mortgage, where the capital is not repaid
throughout the term. This type of mortgage is common in the UK,
especially when associated with a regular investment plan. With
this arrangement regular contributions are made to a separate
investment plan designed to build up a lump sum to repay the
mortgage at maturity. This type of arrangement is called an
investment-backed mortgage or is often related to the type
of plan used:
endowment mortgage
if an endowment policy is used, similarly a
Personal Equity Plan (PEP) mortgage,
Individual Savings
Account (ISA) mortgage or
pension mortgage. Historically,
investment-backed mortgages offered various tax advantages over
repayment mortgages, although this is no longer the case in the UK.
Investment-backed mortgages are seen as higher risk as they are
dependent on the investment making sufficient return to clear the
debt.
Until recently it was not uncommon for interest only mortgages to
be arranged without a repayment vehicle, with the borrower gambling
that the property market will rise sufficiently for the loan to be
repaid by trading down at retirement (or when rent on the property
and inflation combine to surpass the interest rate).
No capital or interest
For older borrowers (typically in retirement), it may be possible
to arrange a mortgage where neither the capital nor interest is
repaid. The interest is rolled up with the capital, increasing the
debt each year.
These arrangements are variously called
reverse mortgages,
lifetime mortgages or
equity release
mortgages, depending on the country. The loans are typically
not repaid until the borrowers die, hence the age restriction. For
further details, see
equity
release.
Interest and partial capital
In the U.S. a partial amortization or
balloon loan is one where the amount of monthly
payments due are calculated (amortized) over a certain term, but
the outstanding capital balance is due at some point short of that
term. In the UK, a part repayment mortgage is quite common,
especially where the original mortgage was investment-backed and on
moving house further borrowing is arranged on a capital and
interest (repayment) basis.
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.
Mortgage lending: United States
United States mortgage process
In the U.S., the process by which a mortgage is secured by a
borrower is called origination. This involves the borrower
submitting a
Loan application and
documentation related to his/her financial history and/or credit
history to the underwriter. Many banks now offer "no-doc" or
"low-doc" loans in which the borrower is required to submit only
minimal financial information. These loans carry a higher interest
rate and are available only to borrowers with excellent credit.
Sometimes, a third party is involved, such as a mortgage broker.
This entity takes the borrower's information and reviews a number
of lenders, selecting the ones that will best meet the needs of the
consumer.
Loans are often sold on the open market to larger investors by the
originating mortgage company. Many of the guidelines that they
follow are suited to satisfy investors. Some companies, called
correspondent lenders, sell all or most of their closed loans to
these investors, accepting some risks for issuing them. They often
offer niche loans at higher prices that the investor does not wish
to originate.
If the
underwriter is not satisfied with
the documentation provided by the borrower, additional
documentation and conditions may be imposed, called stipulations.
The meeting of such conditions can be a daunting experience for the
consumer, but it is crucial for the lending institution to ensure
the information being submitted is accurate and meets specific
guidelines. This is done to give the lender a reasonable guarantee
that the borrower can and will repay the loan. If a third party is
involved in the loan, it will help the borrower to clear such
conditions.
The following documents are typically required for traditional
underwriter review. Over the past several years, use of "automated
underwriting" statistical models has reduced the amount of
documentation required from many borrowers. Such automated
underwriting engines include
Freddie
Mac's "Loan Prospector" and
Fannie
Mae's "Desktop Underwriter". For borrowers who have excellent
credit and very acceptable debt positions, there may be virtually
no documentation of income or assets required at all. Many of these
documents are also not required for no-doc and low-doc loans.
- Credit Report
- 1003 — Uniform Residential Loan Application
- 1004 — Uniform
Residential Appraisal Report
- 1005 — Verification Of Employment (VOE)
- 1006 — Verification Of Deposit (VOD)
- 1007 — Single Family Comparable Rent Schedule
- 1008 — Transmittal Summary
- Copy of deed of current home
- Federal income tax records for last two years
- Verification of Mortgage (VOM) or Verification of Payment
(VOP)
- Borrower's Authorization
- Purchase Sales Agreement
- 1084A and 1084B (Self-Employed Income Analysis) and 1088
(Comparative Income Analysis) - used if borrower is
self-employed
Predatory mortgage lending
There is concern in the U.S. that consumers are often victims of
predatory mortgage
lending [400806]. The main concern is that mortgage brokers
and lenders, operating legally, are finding
loopholes in the law to obtain additional profit.
The typical scenario is that terms of the loan are beyond the means
of the borrower. The borrower makes a number of interest and
principal payments, and then defaults. The lender then takes the
property and recovers the amount of the loan, and also keeps the
interest and principal payments, as well as loan origination
fees.
Option ARM
An option ARM provides the option to pay as little as the
equivalent of an amortized payment based on a 1% interest rate,
(please note this is not the actual interest rate). As a result,
the difference between the monthly payment and the interest on the
loan is added to the loan principal; the loan at this point has
negative amortization. In this
respect, an option ARM provides a form of equity withdrawal (as in
a cash-out refinancing) but over a period of time.
The option ARM gives a number of payment choices each month (for
example, the equivalent of an amortized payment where the interest
rate 1%, interest only based on actual interest rate, actual 30
year amortized payment, actual 15 year amortized payment). The
interest rate may adjust every month in accordance with the index
to which the loan is tied and the terms of the specific loan. These
loans may be useful for people who have a lot of equity in their
home and want to lower monthly costs; for investors, allowing them
the flexibility to choose which payment to make every month; or for
those with irregular incomes (such as those working on commission
or for whom bonuses comprise a large portion of income).
One of the important features of this type of loan is that the
minimum payments are often fixed for each year for an initial term
of up to 5 years. The minimum payment may rise each year a little
(payment size increases of 7.5% are common) but remain the same for
another year. For example, a minimum payment for year 1 may be
$1,000 per month each month all year long. In year 2 the minimum
payment for each month is $1,075 each month. This is a gradual
increase in the minimum payment. The interest rate may fluctuate
each month, which means that the extent of any negative
amortization cannot be predicted beyond worst-case scenario as
dictated by the terms of the loan.
Option ARM mortgages have been criticized on the basis that some
borrowers are not aware of the implications of negative
amortization; that eventually option ARMs reset to higher payment
levels (an event called "recast" to amortize the loan), and
borrowers may not be capable of making the higher monthly payments;
and that option ARMs have been used to qualify mortgages for
individuals whose incomes cannot support payments higher than the
minimum level.
Costs
Lenders may charge various fees when giving a mortgage to a
mortgagor. These include entry fees, exit fees, administration fees
and
lenders mortgage
insurance. There are also settlement fees (
closing costs) the settlement company will
charge. In addition, if a third party handles the loan, it may
charge other fees as well.
The United States mortgage finance industry
Mortgage lending is a major category of the business of
finance in the United States. Mortgages are
commercial paper and can be conveyed and
assigned freely to other holders. In the U.S., the
Federal government
created several programs, or
government sponsored entities,
to foster mortgage lending, construction and encourage
home ownership. These programs include the
Government
National Mortgage Association (known as Ginnie Mae), the
Federal National
Mortgage Association (known as Fannie Mae) and the
Federal Home Loan
Mortgage Corporation (known as Freddie Mac). These programs
work by buying a large number of mortgages from banks and issuing
(at a slightly lower interest rate) "mortgage-backed bonds" to
investors, which are known as
mortgage-backed securities
(MBS).
This allows the banks to quickly relend the money to other
borrowers (including in the form of mortgages) and thereby to
create more mortgages than the banks could with the amount they
have on deposit. This in turn allows the public to use these
mortgages to purchase homes, something the government wishes to
encourage. The investors, meanwhile, gain low-risk income at a
higher interest rate (essentially the mortgage rate, minus the cuts
of the bank and GSE) than they could gain from most other
bonds.
Securitization is a momentous change in the way that mortgage bond
markets function, and has grown rapidly in the last 10 years as a
result of the wider dissemination of technology in the mortgage
lending world. For borrowers with superior credit, government loans
and ideal profiles, this securitization keeps rates almost
artificially low, since the pools of funds used to create new loans
can be refreshed more quickly than in years past, allowing for more
rapid outflow of capital from investors to borrowers without as
many personal business ties as the past.
The increased amount of lending led (among other factors) to the
United States housing
bubble of 2000-2006. The growth of lightly regulated
derivative instruments based on
mortgage-backed securities, such as
collateralized debt
obligations and
credit default
swaps, is widely reported as a major causative factor behind
the
2007
subprime mortgage financial crisis.
Second-layer lenders in the US
A group called
second-layer lenders became an important
force in the residential mortgage market in the latter half of the
1960s. These federal credit agencies, which include the Federal
Home Loan Mortgage Corp., the Federal National Mortgage
Association, and the Government National Mortgage Association,
conduct secondary market activities in the buying and selling of
loans and provide credit to primary lenders in the form of borrowed
money. They do not have direct contact with the individual
consumer.
Federal Home Loan Mortgage Corporation
The
Federal Home
Loan Mortgage Corporation, sometimes known as
Freddie Mac, was established in 1970. This
corporation is designed to promote the flow of capital into the
housing market by establishing an active secondary market in
mortgages. It may by law deal only with government-supervised
lenders such as savings and loan associations, savings banks, and
commercial banks; its programs cover conventional whole mortgage
loans, participations in conventional loans, and
FHA and
VA loans.
Federal National Mortgage Association
The
Federal
National Mortgage Association, known in financial circles as
Fannie Mae, was chartered as a government
corporation in 1938, rechartered as a federal agency in 1954, and
became a government-sponsored, stockholder-owned corporation in
1968. Fannie Mae, which has been described as "a private
corporation with a public purpose", basically provides a secondary
market for residential loans. It fulfills this function by buying,
servicing, and selling loans that, since 1970, have included
FHA-insured, VA-guaranteed, and conventional loans. However,
purchases outrun sales by such a wide margin that some observers
view this association as a lender with a permanent loan portfolio
rather than a powerful secondary market corporation.
Government National Mortgage Association
The
Government
National Mortgage Association, which is often referred to as
Ginnie Mae, operates within the Department of Housing and Urban
Development
. In addition to performing the special
assistance, management, and liquidation functions that once
belonged to Fannie Mae, Ginnie Mae has an important additional
function — that of issuing guarantees of securities backed by
government-insured or guaranteed mortgages. Such mortgage-backed
securities are fully guaranteed by the
U.S. government as to timely payment of both
principal and interest.
Delinquency
At the start of 2008, 5.6% of all mortgages in the United States
were
delinquent. By the end of the first
quarter that rate had risen, encompassing 6.4% of residential
properties. This number did not include the 2.5% of homes in
foreclosure.
Competition among US lenders for loanable funds
To be able to provide homebuyers and builders with the funds
needed,
financial institutions
must compete for deposits.
Consumer
lending institutions compete for loanable funds not only among
themselves but also with the
federal government
and private
corporations.
Called disintermediation, this process involves
the movement of dollars from savings accounts into direct market
instruments: U.S.
Treasury obligations, agency securities, and corporate
debt. One of the greatest factors in recent years in the
movement of deposits was the tremendous growth of money market
funds whose higher interest rates attracted consumer
deposits.
To compete for deposits, US savings institutions offer many
different types of plans:
- Passbook or ordinary accounts — permit any amount to be added to or
withdrawn from the account at any time.
- NOW and Super NOW accounts — function like checking accounts
but earn interest. A minimum balance may be required on Super NOW
accounts.
- Money market accounts —
carry a monthly limit of preauthorized transfers to other accounts
or persons and may require a minimum or average balance.
- Certificate accounts — subject to loss of some or all interest
on withdrawals before maturity.
- Notice accounts — the equivalent of certificate accounts with
an indefinite term. Savers agree to notify the institution a
specified time before withdrawal.
- Individual retirement
accounts (IRAs) and Keogh
accounts—a form of retirement savings in which the funds
deposited and interest earned are exempt from income tax until
after withdrawal.
- Checking accounts — offered by
some institutions under definite restrictions.
- Club accounts and other savings
accounts—designed to help people save regularly to meet certain
goals.
Mortgages in the UK
The mortgage loans industry and market
There are currently over 200 significant separate financial
organizations supplying mortgage loans to house buyers in Britain.
The major lenders include building societies, banks, specialized
mortgage corporations, insurance companies, and pension funds. Over
the years, the share of the new mortgage loans market held by
building societies has declined. Between 1977 and 1987, it fell
drastically from 96% to 66% while that of banks and other
institutions rose from 3% to 36%. The banks and other institutions
that made major inroads into the mortgage market during this period
were helped by such factors as:
- relative managerial efficiency;
- advanced technology, organizational capabilities, and expertise
in marketing;
- extensive branch networks; and
- capacities to tap cheaper international sources of funds for
lending.
By the early 1990s, UK building societies had succeeded in greatly
slowing if not reversing the decline in their market share. In
1990, the societies held over 60% of all mortgage loans but took
over 75% of the new mortgage market – mainly at the expense of
specialized mortgage loans corporations. Building societies also
increased their share of the personal savings deposits market in
the early 1990s at the expense of the banks – attracting 51% of
this market in 1990 compared with 42% in 1989. One study found that
in the five years 1987-1992, the building societies collectively
outperformed the UK clearing banks on practically all the major
growth and performance measures. The societies' share of the new
mortgage loans market of 75% in 1990-91 was similar to the share
level achieved in 1985. Profitability as measured by return on
capital was 17.8% for the top 20 societies in 1991, compared with
only 8.5% for the big four banks. Finally, bad debt provisions
relative to advances were only 0.4% for the top 20 societies
compared with 2.8% for the four banks.
Though the building societies did subsequently recover a
significant amount of the mortgage lending business lost to the
banks, they still only had about two-thirds of the total market at
the end of the 1980s. However, banks and building societies were by
now becoming increasingly similar in terms of their structures and
functions. When the Abbey National building society converted into
a bank in 1989, this could be regarded either as a major
diversification of a building society into retail banking – or as
significantly increasing the presence of banks in the residential
mortgage loans market. Research organization Industrial Systems
Research has observed that trends towards the increased integration
of the financial services sector have made comparison and analysis
of the market shares of different types of institution increasingly
problematical. It identifies as major factors making for
consistently higher levels of growth and performance on the part of
some mortgage lenders in the UK over the years:
- the introduction of new technologies, mergers, structural
reorganization and the realization of economies of scale, and
generally increased efficiency in production and marketing
operations – insofar as these things enable lenders to reduce their
costs and offer more price-competitive and innovative loans and
savings products;
- buoyant retail savings receipts, and reduced reliance on
relatively expensive wholesale markets for funds (especially when
interest rates generally are being maintained at high levels
internationally);
- lower levels of arrears, possessions, bad debts, and
provisioning than competitors;
- increased flexibility and earnings from secondary sources and
activities as a result of political-legal deregulation; and
- being specialized or concentrating on traditional core,
relatively profitable mortgage lending and savings deposit
operations.
Mortgage types
The UK mortgage market is one of the most innovative and
competitive in the world. Unlike some other countries, there is
little intervention in the market by the
state or state funded entities and virtually
all borrowing is funded by either mutual organisations (
building societies and
credit unions) or proprietary lenders
(typically
banks). Since 1982, when the market
was substantially deregulated, there has been substantial
innovation and diversification of strategies employed by lenders to
attract borrowers. This has led to a wide range of mortgage
types.
As lenders
derive their funds either from the money
markets or from deposits, most mortgages revert to a
variable
rate, either the lender's standard variable
rate or a tracker rate, which will tend
to be linked to the underlying Bank of England
(BoE) repo rate (or
sometimes LIBOR). Initially they will tend to offer an
incentive deal to attract new borrowers. This may be:
- A fixed rate; where the interest rate remains
constant for a set period; typically for 2, 3, 4, 5 or 10 years.
Longer term fixed rates (over 5 years) whilst available, tend to be
more expensive and/or have more onerous early repayment charges and
are therefore less popular than shorter term fixed rates.
- A capped rate; where similar to a fixed rate,
the interest rate cannot rise above the cap but can vary
beneath the cap. Sometimes there is a collar
associated with this type of rate which imposes a minimum rate.
Capped rate are often offered over periods similar to fixed rates,
e.g. 2, 3, 4 or 5 years.
- A discount rate; where there is set margin
reduction in the standard variable rate (e.g. a 2% discount) for a
set period; typically 1 to 5 years. Sometimes the discount is
expressed as a margin over the base rate (e.g. BoE base rate plus
0.5% for 2 years) and sometimes the rate is stepped (e.g. 3% in
year 1, 2% in year 2, 1% in year three).
- A cashback mortgage; where a lump sum is
provided (typically) as a percentage of the advance e.g. 5% of the
loan.
To make matters more confusing these rates are often combined: For
example, 4.5% 2 year fixed then a 3 year tracker at BoE rate plus
0.89%.
With each incentive the lender may be offering a rate at less than
the market cost of the borrowing. Therefore, they typically impose
a penalty if the borrower repays the loan within the incentive
period or a longer period (referred to as an
extended
tie-in). These penalties used to be called a
redemption
penalty or
tie-in, however since the onset of
Financial Services
Authority regulation they are referred to as an
early
repayment charge.
"Self Cert" mortgage
Mortgage lenders usually use salaries declared on wage slips to
work out a borrower's annual income and will usually lend up to a
fixed multiple of the borrower's annual income. Self Certification
Mortgages, informally known as "self cert" mortgages, are available
to employed and self employed people who have a deposit to buy a
house but lack the sufficient documentation to prove their
income.
This type of mortgage can be beneficial to people whose income
comes from multiple sources, whose salary consists largely or
exclusively of commissions or bonuses, or whose accounts may not
show a true reflection of their earnings. Self cert mortgages have
two disadvantages: the interest rates charged are usually higher
than for normal mortgages and the
loan to
value ratio is usually lower.
100% mortgages
Normally when a bank lends a customer money they want to protect
their money as much as possible; they do this by asking the
borrower to fund a certain percentage of the property purchase in
the form of a deposit.
100% mortgages are mortgages that require no deposit (100% loan to
value). These are sometimes offered to first time buyers, but
almost always carry a higher interest rate on the loan.
Together/Plus mortgages
A development of the theme of 100% mortgages is represented by
Together/Plus type mortgages, which have been launched by a number
of lenders in recent years.
Together/Plus Mortgages represent loans of 100% or more of the
property value - typically up to a maximum of 125%. Such loans are
normally (but not universally) structured as a package of a 95%
mortgage and an unsecured loan of up to 30% of the property value.
This structure is mandated by lenders' capital requirements which
require additional capital for loans of 100% or more of the
property value.
UK mortgage process
UK lenders usually charge a
valuation
fee, which pays for a
chartered surveyor
to visit the property and ensure it is worth enough to cover the
mortgage amount. This is not a full survey so it may not identify
all the defects that a house buyer needs to know about. Also, it
does not usually form a
contract between
the surveyor and the buyer, so the buyer has no right to sue if the
survey fails to detect a major problem. For an extra fee, the
surveyor can usually carry out a building survey or a (cheaper)
"homebuyers survey" at the same time.
Mortgage lending in Continental Europe
Within the
European Union, the
Covered bonds market volume (covered
bonds outstanding) amounted to about EUR 2 trillion at year-end
2007 with Germany, Denmark, Spain, and France each having
outstandings above 200,000 EUR million. In German language,
Pfandbriefe is the term applied.
Pfandbrief-like securities have been introduced in more than 25
European countries – and in recent years also in the U.S. and other
countries outside Europe – each with their own unique law and
regulations. However, the diffusion of the concept differ: In 2000,
the US institutions Fannie Mae and Freddie Mac together reached one
per cent of the national population. Furthermore, 87 per cent of
their purchased mortgages were granted to borrowers in metropolitan
areas with higher income levels. In Europe, a wider market has been
achieved: In Denmark, mortgage banks reached 35 per cent of the
population in 2002, while the German Bausparkassen achieved
widespread regional distribution and more than 30 per cent of the
German population concluded a Bauspar contract (as of 2001).
Costs
A study issued by the UN
Economic Commission for
Europe compared German, US, and Danish mortgage systems. The
German Bausparkassen have reported nominal interest rates of
approximately 6 per cent per annum in the last 40 years (as of
2004). In addition, they charge administration and service fees
(about 1.5 per cent of the loan amount). In the United States, the
average interest rates for fixed-rate mortgages in the housing
market started in high double figures in the 1980s and have (as of
2004) reached about 6 per cent per annum. However, gross borrowing
costs are substantially higher than the nominal interest rate and
amounted for the last 30 years to 10.46 per cent. In Denmark,
similar to the United States capital market, interest rates have
fallen to 6 per cent per annum. A risk and administration fee
amounts to 0.5 per cent of the outstanding debt. In addition, an
acquisition fee is charged which amounts to one per cent of the
principal.
Recent trends
July 28,
2008, US
Treasury
Secretary
Henry Paulson announced that, along with four large US banks, the
Treasury would attempt to kick-start a market for these securities
in the U.S., primarily to provide an alternative form of
mortgage-backed securities. Similarly, in the UK "the
Government is inviting views on options for a UK framework to
deliver more affordable long-term fixed-rate mortgages, including
the lessons to be learned from international markets and
institutions". More specifically, Mr.
George Soros issued a
Wall Street Journal Opinion: Denmark
Offers a Model
Mortgage
Market.
- A survey of European Pfandbrief-like
products was issued in 2005 by the Bank for
International Settlements
; the International Monetary Fund
in 2007 issued a study of the covered bond markets in Germany and Spain,
while the European
Central Bank
in 2003 issued a study of housing markets,
addressing also mortgage markets and providing a two page overview
of current mortgage systems in the EU countries.
History
While the idea originated in Prussia in 1769, a Danish act on
mortgage credit associations of 1850 enabled the issuing of bonds
(Danish: Realkreditobligationer) as a means to refinance mortgage
loans . With the German mortgage banks law of 1900, the whole
German Empire was given a standardized legal foundation for the
emission of Pfandbriefe. An account from the perspective of
development economics is available.
Mortgage insurance
Mortgage insurance is an insurance policy designed
to protect the mortgagee (lender) from any default by the mortgagor
(borrower). It is used commonly in loans with a
loan-to-value ratio over 80%, and
employed in the event of
foreclosure and
repossession.
This policy is typically paid for by the borrower as a component to
final nominal (note) rate, or in one lump sum up front, or as a
separate and itemized component of monthly mortgage payment. In the
last case, mortgage insurance can be dropped when the lender
informs the borrower, or its subsequent assigns, that the property
has appreciated, the loan has been paid down, or any combination of
both to relegate the loan-to-value under 80%.
In the event of repossession, banks, investors, etc. must resort to
selling the property to recoup their original investment (the money
lent), and are able to dispose of hard assets (such as real estate)
more quickly by reductions in price. Therefore, the mortgage
insurance acts as a hedge should the repossessing authority recover
less than full and fair market value for any hard asset.
Islamic mortgages
The
Sharia law of
Islam
prohibits the payment or receipt of
interest, which means that practising Muslims
cannot use conventional mortgages. However, real estate is far too
expensive for most people to buy outright using cash: Islamic
mortgages solve this problem by having the property change hands
twice. In one variation, the bank will buy the house outright and
then act as a landlord. The homebuyer, in addition to paying
rent, will pay a contribution towards
the purchase of the property. When the last payment is made, the
property changes hands.
Typically, this may lead to a higher final price for the buyers.
This is because in some countries (such as the United Kingdom and
India) there is a
Stamp Duty which is a
tax charged by the government on a change of ownership. Because
ownership changes twice in an Islamic mortgage, a stamp tax may be
charged twice. Many other jurisdictions have similar transaction
taxes on change of ownership which may be levied. In the United
Kingdom, the dual application of
Stamp
Duty in such transactions was removed in the Finance Act 2003
in order to facilitate Islamic mortgages.
An alternative scheme involves the bank reselling the property
according to an installment plan, at a price higher than the
original price.
Both of these methods compensate the lender as if they were
charging interest, but the loans are structured in a way that in
name they are not, and the lender shares the financial risks
involved in the transaction with the homebuyer.
Other terminologies
Like any other legal system, the mortgage business sometimes uses
confusing jargon. Below are some terms explained in brief. If a
term is not explained here it may be related to the
legal mortgage rather than to
the loan.
AdvanceThis is the money
you have borrowed plus all the additional fees.
Base rateIn 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 loanThis is
a temporary loan that enables the borrower to purchase a new
property before the borrower is able to sell another current
property.
DisbursementsThese 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
penaltyThis is the amount of money due if the mortgage is
paid in full before the time finished.
equityThis is the
market value of the property minus all loans outstanding on
it.
First time
buyerThis is the term given to a person buying
property for the first time.
Loan origination feeA charge levied by a creditor
for underwriting a loan. The fee often is expressed in points. A
point is 1 percent of the loan amount.
Sealing feeThis is a fee made when the lender
releases the legal charge over the property.
Subject to contractThis is an agreement between
seller and buyer before the actual contract is made.
See also
General, or related to more than one nation
Related to the United Kingdom
Related to the United States
Other nations
Legal details
References
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