Mortgage is a form of secured lending where money is borrowed against a property. Essentially, a borrower has to provide a property as collateral to a lender, who in turn provides money on predefined terms agreed between the lender & the borrower. Hence, any borrowing based on property as collateral is a Mortgage. Today, in most countries, Mortgage Lending is the primary means of owning a property (both Residential & Commercial) since very few people have the monetary liquidity to purchase a property outright.
Though, there would some variations from one country to another depending on domestic market and other conditions, overall the concepts remain the same.
In most cases, the amount lent is a certain percentage (usually around 80-85%) of the value of the property which is either the fair market value as determined by surveyors or the value at which the property is being bought by the borrower. The balance, which the borrower needs to pay in the form of down payment, is the home owner’s Equity on the asset. The ratio of the amount lent to the home owner’s equity is known as LTV (Loan to Value). The higher the home owner’s equity or lower the LTV on the asset, the less risky is the loan to the lender. However, in case of a payment default by the borrower, the higher the equity of the borrower, the higher is his loss. Since, an encumbrance is created on property for Mortgage Lending, the lender reverses the right to repossess & sell off the property to recover the debt in the event of payment default by the borrower. However, in most cases, the borrower is still liable to pay the debt if the sale of the property does not regain the amount originally lent to the borrower. Like any other kind of lending, Mortgage Loans also include a rate of interest which is the cost of borrowing for the borrower. On the other hand, the rate of interest reflects the cost of fund of the lender along with the perceived default risk of the loan by the lender. Interest Rates in Mortgage Loans are either fixed rates or floating rates. Fixed Rate loans are ones where the interest rate is fixed throughout the life of the loan. In the Floating Rate loans, the interest rates are generally linked to some benchmark index like LIBOR (London Interbank Offer Rate) and are revised periodically, typically every quarter or six months. In a Floating Rating loan, a part of the risk of increase in the cost of fund of the lender is transferred to the borrower and hence, usually, the initial rate of interest is lower than that of Fixed Rate loans. Further, the rate of interest also depends on the creditworthiness & credit score of the borrower. The lower the credit score or credit history of the borrower, higher the interest charged since the default risk is higher.
Broadly, Mortgage Lending can be divided into the following subcategorises:
- The traditional Lending which is a long term loan where the money is lent as principal for buying a property and then the principal+interest is amortised over a period of time (conventionally 25-30 years)
- Home Equity Loan is the loan where encumbrance is created on the property owned by the borrower and used as collateral. This can be a first/second/less likely third charge and hence reduces the owner’s equity on the asset. Home Equity Loan can be a lump-sum loan, usually with a fixed rate of interest or it can be a revolving line of credit where the borrower pays interest only on the amount utilised. The rate of interest in this case is usually a Floating Rate. The tenor for Home Equity Loans is generally shorter than the traditional Mortgage Loans
- Reverse Mortgage or Equity Release where the property is used to generate a steady stream of income and the loan is repaid usually after the death of the borrower (or after the borrower vacates the property) by selling the property
Whether a borrower should take a Mortgage Loan or a Home Equity Loan depends on the underlying reason of requirement of the loan.
A property buyer would need to go for the traditional mortgage loan. However, depending on the current as well as the borrower’s perception of the future rate of interest in the market, one would opt for a Fixed or a Floating rate loan. If the borrower perceives that the chances of rate of interest going up in future is higher, he/she would choose the Fixed Rate option, while if the perception is that the current interest rate if too high and that it should go down in future, one would choose the Floating Rate option. In this case, the underlying reason for the loan is to buy the property and hence the loan amount borrowed cannot be diverted to any other use. On the other hand, a borrower who wants to leverage his/her property to borrow funds would need to look for the Home Equity Loan. However, depending on whether the requirement is one-shot or a recurring one, one needs to go for the lump-sum option or the revolving credit line, also known Home Equity Line of Credit (HELOC) respectively. In this case, however, the borrower is free to use the loan fund in any way he/she wants as long as it does not involve any activity restricted by the lender since the underlying objective is to leverage the borrower’s equity in the asset to borrow funds for other use.