Overview

Welcome to the module on “Mortgages and Mortgage-Backed Securities.” This chapter serves as an introduction to the fascinating world of mortgages and the financial instruments known as mortgage-backed securities (MBS). Mortgages play a pivotal role in the real estate industry by enabling individuals to purchase homes through financing. Mortgage-backed securities, on the other hand, are complex financial products that derive their value from the underlying mortgages. In this chapter, we will provide an overview of the key concepts, learning objectives, and the significance of understanding mortgages and MBS in the broader financial landscape.

Understanding Mortgages

Mortgages are loans specifically designed for real estate purchases. They allow individuals to buy homes without having to pay the full purchase price upfront. Instead, the buyer makes a down payment and borrows the remaining amount from a lender, typically a bank or mortgage company. The loan is secured by the property itself, which means that if the borrower fails to make timely payments, the lender can take possession of the property through a legal process known as foreclosure.

Role of Interest Rates: Fixed-Rate vs. Adjustable-Rate Mortgages

One of the critical aspects of mortgages is the interest rate. The interest rate on a mortgage determines the cost of borrowing and affects the monthly payments. There are two main types of mortgages based on interest rates:

• Fixed-Rate Mortgage: In a fixed-rate mortgage, the interest rate remains constant throughout the life of the loan. This provides borrowers with predictability and stability in their monthly payments. The principal and interest components of each payment stay the same, although the proportion of each changes over time due to amortization.

• Adjustable-Rate Mortgage (ARM): An ARM has an interest rate that adjusts periodically based on a specified benchmark, such as the U.S. Prime Rate or the London Interbank Offered Rate (LIBOR). These mortgages often have an initial fixed-rate period, followed by adjustments at predefined intervals. The variability of interest rates can lead to varying monthly payments.

Introduction to Mortgage-Backed Securities (MBS)

Mortgage-backed securities (MBS) are financial instruments that represent ownership in a pool of mortgages. These pools consist of individual home loans that have been bundled together and sold to investors. The cash flows generated by the underlying mortgage payments are then passed through to MBS holders. The securitization process, which involves the packaging and selling of these pools, helps financial institutions manage risk and liquidity.

Significance in Financial Markets

Mortgages and mortgage-backed securities are fundamental to the functioning of financial markets. They provide opportunities for investors to diversify their portfolios and manage risk exposure. At the same time, they offer homeowners the ability to access affordable financing to purchase homes. Understanding how mortgages are structured, how MBS are created, and how they are traded is crucial for financial professionals and investors alike.