Bonds and Bond Derivatives, Second Edition

13

MORTGAGES

A mortgage is a loan with real estate pledged as collateral. If the borrower defaults on the loan, the lender has first claim upon the real estate. The pledged real estate can be residential property or commercial property.

Interest rates on mortgages can be fixed over the life of the mortgage (fixed rate) or the interest rate may be tied to some interest rate index and vary over time (called variable rate, floating rate, or adjustable rate). With fixed-rate mortgages, the lender bears the risk of changing interest rates. With floating-rate mortgages, the borrower bears the risk of changing interest rates. The interest cost is lower, on average, for floating-rate loans. The fixed-rate borrower pays a higher interest cost to lock-in the interest cost.

Virtually all mortgages in the United States allow the borrower to repay the principal before final maturity, although the early repayment option is less common in other countries. Repayment occurs primarily for two reasons: (1) sale of a property or (2) refinancing of the mortgage after a decline in interest rates.

In the past, the mortgage market was much more of a localized market. Individuals made deposits in local banks and thrifts, which made mortgage loans locally. The lender typically held the mortgage until maturity. With these localized markets, disparities in interest rates occurred. Mortgage borrowers in some areas paid higher rates than in other areas. Today, with a national mortgage market, borrowing rates ...