Types of Mortgages from Borrower’s Point of View

In the previous article, we studied about the different types of loans from the lenders point of view. Therefore we looked at the classification of the loans based on the types of borrowers. In this article we will look at the different types of loans from the borrower’s point of view. Since the US mortgage market was highly diversified, borrowers had innumerable options to choose from. This article provides an indicative list. The following are the most common types of loans.

Amortized Loans

The regular types of mortgage loans that are made worldwide are called amortization loans. This is because these loans follow a financial procedure called amortization. Amortization means principal and interest payments are being made simultaneously in a monthly payment. The amount of the monthly payment remains the same i.e. it is an annuity.

However, the monthly payment has two parts interest and principal. In the beginning of the loan the interest payments are highest. This is because the outstanding principal is highest. However, during the tenure of the loan as more and more principal is paid back the interest component reduces and more money starts going towards the principal repayment. During the last few payments, almost the entire payment consists of principal as there is hardly any interest left to pay. These loans are the most regular types of loans and carry the minimal risk from the lenders point of view. This is the most conservative type of lending.

Interest Only Loans

The interest only loans are the exact opposite of amortized loans. These loans do not follow the amortization procedure. In this case, the borrower is only expected to make monthly interest payments. Since these are no principal payments being made, the amount of principal does not reduce and the interest outstanding remains the same each month. Let’s understand this with the help of an example.

In case a borrower was to borrow $100 in an interest only mortgage at a 0.25% per month interest only loan, they were liable to pay only 25 cents every month. However, the interest will remain constant at 25 cents until the rates change. Also, the principal will remain constant at $100. Even if the borrower paid the mortgage payments for 20 years there would still be the $100 principal outstanding. Since the principal is never paid off, and the value of the house may fluctuate in value, these types of loans are considered very risky from the lenders point of view. A borrower may suddenly go underwater if a mortgage is structured this way and that is what happened in the subprime mortgage crisis. The interest rates on these types of loans are generally higher than the interest rates on amortized loans.

Also, these loans are largely used by speculators i.e. people who have no interest in moving into the house. Rather they just want to keep paying interest till as long as they hold their investment.

Bullet Payment Loans

The third type of loan from the borrower’s point of view is the bullet payment loan. In many ways it is a hybrid between the earlier two types of loans. The bullet payment loan is like the interest only loan in the sense that the borrower only has to make monthly interest payments. However, it is also like the amortization loan in the sense that the borrower has to make principal payments at certain specified intervals. Let’s understand this with the help of an example.

So if a borrower takes a $100 bullet mortgage loan with a 0.25% monthly interest, then the borrower has to pay 25 cents every month for the interest payments. Then, they also have to pay $10.25 in the 12th month (or any month agreed upon). Here $10 will go towards principal payments whereas 25 cents will go towards interest payments.

Once again, these loans were largely used by speculators who did not intend to hold on the property till the bullet payment came due.

Piggyback Loans: Piggyback loans were the start of deteriorating lending standards. These loans were basically meant to cover the mortgage margin payments. Quasi-Government agencies like Freddie Mac and Fannie Mae required that the borrowers finance at least 20% of the loan value. Hence, banks started lending them this 20% in the form of piggyback loans. This was a separate loan account. The borrower would then use this money to pay the margin money and the resultant loan could then be sold off in the secondary mortgage markets to these quasi government agencies. This was a way of circumventing the regulation. In essence the borrower had put no money down but it appeared as though they had put 20% margin payments.

No Documentation: Lenders in the midst of a borrowing boom were finding it hard to find enough people to give money to. It is for this reason that they had to relax the conventional mortgage lending norms. Conventional mortgage lending relied extensively on paperwork. Documents were required to ascertain the net worth of the individual as well as their projected cash flows. In the midst of the lending mania, lenders decided to ignore all of this. Loans were given out to people who did not have regular jobs or income documents. Instead, people could just self verify their income and the documents would be considered to be good enough for the bank’s purposes.

Ninja Loans: Perhaps the most outrageous type of loan during the subprime mortgage crisis was the NINJA loan. NINJA stands for No Income, No Jobs and No Assets. Conventional lending would have frowned upon such an application for thousands of dollars worth mortgage loans. However, new age lenders decided that they were actually lending against a security i.e. a house and therefore could make such loans. NINJA loans were given to pretty much anybody that a decent credit score i.e. they were not delinquent in their credit history. Hence, if a person had just migrated from another country and had no job, no income and no assets, they could qualify for a mortgage! Even people who just got their credit scores immediately got a mortgage! Stories of people working menial jobs and having multiple homes were not uncommon during this era.

Although the lending standards were severely compromised in these types of loans, the market still had some innovations left. In the next article we shall have a closer look at two of the most important such innovations. They were important because they changed the very nature of the housing market.

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