Residential mortgage loans: the features that matter

What is a residential mortgage loan?

A mortgage loan is a loan secured by a specified property. The lender holds a first lien : a legal claim on the property that ranks ahead of other claims. If the borrower stops paying, the lender can start foreclosure , take possession of the property and sell it to recover the debt.

Buyers usually borrow less than the purchase price. The difference is the down payment , and it is the borrower’s equity on day one. Everything else in this lesson is about how much of a cushion the lender has, and what rights each side holds.

How do lenders measure the cushion? LTV and DTI

Two ratios carry most of the weight. The loan-to-value ratio measures the equity cushion in the property. The debt-to-income ratio measures the borrower’s ability to make the payments from income. Lower is safer for both.

$$\text{LTV} = \frac{\text{Loan amount}}{\text{Property value}}$$

$$\text{DTI} = \frac{\text{Monthly debt payments}}{\text{Monthly gross income}}$$

DTI uses pre-tax (gross) income and all monthly debt payments, not just the mortgage. LTV matters for commercial mortgages too (lesson 4).

Questions ask for either ratio, or for the input that is missing.

LTV does not stay put. Repayments reduce the balance, which pushes it down. A fall in the home’s price pushes it up. A loan with LTV above 100% is in negative equity , also called “underwater”: the home is worth less than the debt.

What kinds of borrower and guarantee exist?

In the US, lenders separate prime loans from subprime loans . Prime borrowers have strong employment and credit histories, a low DTI, substantial equity and a first lien. Subprime loans have weaker credit, a high DTI or LTV, or are secured by a second lien (ranking behind another lender).

Residential mortgage-backed securities (RMBS), which are securities backed by residential mortgages, are also split by who guarantees them. agency RMBS are backed by a federal agency or a government-sponsored enterprise (GSE). Federal agency RMBS carry the full faith and credit of the government; GSE RMBS carry the GSE’s own guarantee of timely interest and principal, for which it charges a fee. non-agency RMBS (private label) have no guarantee, so they use credit enhancements to reach acceptable quality.

US residential MBSthree sectors by guarantor

• Agency RMBS Memorize the first two sectors
  • Federal agency Memorize full faith and credit of the government
  • Government-sponsored enterprise (GSE) Memorize the GSE guarantees timely interest and principal, for a fee; not the government
• Non-agency RMBS Memorize private label; issued by private entities
  • No guarantee Memorize relies on credit enhancement
  • Credit enhancements Use it pool insurance, letters of credit, guarantees, subordination

Go deeper Why non-agency RMBS shrank after 2008, and what is back

Non-agency RMBS were often backed by non-conforming or subprime loans. After the global financial crisis, tighter regulation and scrutiny almost wiped the sector out. Some residential loans that rank behind a first mortgage, such as home-improvement loans for solar panels, are now securitized in growing volume. They sit behind the main lender, so their risk differs from a first-lien mortgage.

What options and rights do the parties hold?

The borrower’s most important right is the prepayment option : to repay more than the scheduled principal, in part or in full, before maturity. This creates the prepayment risk of the previous lesson, for any mortgage that allows prepayment. A prepayment penalty compensates the lender if the borrower prepays when rates have fallen. It reduces the incentive to refinance. Penalties are common in Europe and rare in the US.

When a borrower defaults, foreclosure proceeds may fall short of the balance. In a recourse loan , the lender can claim the shortfall from the borrower. In a non-recourse loan , the lender can look only to the property. In the US this is set by state, and residential loans are non-recourse in many states. Most European residential mortgages are recourse loans.

That matters most when LTV is above 100%. A strategic default is a borrower choosing to stop paying, and let the lender foreclose, even though the borrower could keep paying. It is more likely with a non-recourse loan that is deep underwater. A recourse loan makes it less likely, because the shortfall can be recovered from other assets and income.

Exam tip Non-recourse plus negative equity is the combination that points to strategic default.

Put together, these are the things that make one home loan riskier than another.

Mortgage loan riskwho gets hurt if the borrower stops paying

• Equity cushion Memorize loan-to-value ratio; higher means riskier
• Income cushion Memorize debt-to-income ratio; higher means riskier
• Borrower quality Use it
  • Prime strong credit, low DTI, substantial equity, first lien
  • Subprime weaker credit, high DTI or LTV, or second lien
• Contract rights Memorize
  • Prepayment option creates timing risk for investors
  • Prepayment penalty reduces it; common in Europe, rare in the US
  • Recourse or non-recourse decides whether the lender can pursue the borrower for a shortfall

Go deeper What a housing slump does to defaults

When house prices fall after a period of loose lending, many loans slip underwater at once. The pattern is consistent: borrowers who still have equity rarely default, because selling the home beats losing it. The deeper the negative equity, the more defaults rise, and the more of them are strategic, especially where loans are non-recourse. That is why LTV, recourse and the direction of house prices are read together, not one at a time.

Go deeper Fixed and adjustable rates, in one line

Most of this module assumes a level-payment, fixed-rate, fully amortizing mortgage. Adjustable-rate mortgages reset their rate to a reference rate on a schedule, which shifts rate risk toward the borrower. The prepayment option exists either way.