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In: Finance

Explain why a home equity mortgage loan can be a better source of funds for household...

  1. Explain why a home equity mortgage loan can be a better source of funds for household needs than other types of consumer debt.
  2. Give three different ways that an individual could invest in the mortgage market. Include at least one mutual fund that purchases mortgage-backed securities.
  3. In many other capitalistic countries, there are laws requiring a down payment of 20% of the property’s value for residential mortgages. Counterintuitively, homeownership is higher in many of these countries than in the USA (on a percentage basis). In your opinion, why might this be the case?

Solutions

Expert Solution

1) Understanding Home equity mortgage loan

  • Mortgages and home equity loans are both loans in which you pledge your home as collateral.
  • One key difference between a home equity loan and a traditional mortgage is that you take out a home equity loan after you have ownership (equity) in the property, while you take out a mortgage to purchase the property, and start building equity in it.
  • Traditional mortgage, in which a financial institution, like a bank, lends a borrower money to purchase a residence. In most cases, the bank lends up to 80% of the home’s appraised value or the purchase price, whichever is less. For example, if you’re buying a house that's appraised at $200,000, you are eligible for a mortgage of up to $160,000; you must pay the remaining $40,000 on your own.
  • A home equity loan, often referred to as a second mortgage, allows you to borrow money for large expenses or to consolidate debt by leveraging the available equity in your home. Your home equity is based on the difference between the appraised value of your home and your current balance on your mortgage. For example, if you owe $150,000 on a home valued at $250,000, you have $100,000 in equity. Assuming your credit is good, and you otherwise qualify, you can take out an additional loan using that $100,000 as collateral.

Benefits and advantages of a home equity loan as a better source of funds

  1. A home equity loan can be a good option if one needs to cover large expenses associated with home renovations, college tuition, consolidating debt, or other types of major expenses.
  2. Because one can borrow against the value of his home, a home equity loan may also be easier to qualify for than other loans because the loan is secured by the house.
  3. Fixed Rate - Home equity loans typically carry fixed interest rates that are often lower than credit cards or other unsecured consumer loans. In a changing rate environment, a fixed rate loan can provide simplicity in budgeting, because one's monthly payment amount remains the same over the life of the loan and will never increase.
  4. Lump Sum - The amount borrowed with a home equity loan is provided in one lump sum. This offers flexibility to cover large expenses. One can pay back the loan amount with regular monthly payments that go toward accrued interest and principal for the agreed-upon number of years. However, a home equity loan must be paid in full if the house is sold.

  5. Tax Deduction - A tax deduction may be available for the interest one pays on a home equity loan if the loan was used specifically for home renovations.

  6. Home equity loans provide an easy source of cash and can be a valuable tool for responsible borrowers. If one has a steady, reliable source of income and knows that he/she will be able to repay the loan, its low-interest rate and possible tax deductibility make it a sensible choice.

  7. Obtaining a home equity loan is quite simple for many consumers because it is a secured debt. The lender runs a credit check and orders an appraisal of the home to determine the borrower's creditworthiness and the combined loan-to-value ratio.

  8. The interest rate on a home equity loan—although higher than that of a first mortgage—is much lower than that on credit cards and other consumer loans. That helps explain why the primary reason consumers borrow against the value of their homes via a fixed-rate home equity loan is to pay off credit card balances.

  9. Home-equity loans are generally a good choice if one knows exactly how much he/she needs to borrow and what the money will be used for. The borrower is guaranteed a certain amount, which is received in full at closing.
    Home-equity loans are generally preferred for larger, more expensive goals such as remodeling, paying for higher education, or even debt consolidation since the funds are received in one lump sum.

  10. Home equity loans generally have a time period of 5 to 15 years to repay the debt. If used properly, home equity loans can be very beneficial. There is a slight difference between home equity loans and a Home Equity Line of Credit (HELOC). While home equity loans provides with a lump sum of money, a HELOC covers short-term expenses.

  11. Flexibility: Whether it’s a need (home repairs) or a want (lavish vacation), home equity loans can be used for any purpose.

2) Mortgage market

The mortgage market is of two types :- Primary & Secondary.

The primary mortgage market is the market where borrowers can obtain a mortgage loan from a primary lender. Banks, mortgage brokers, mortgage bankers, and credit unions are all primary lenders and are part of the primary mortgage market. Homeowners can deal directly with primary lenders when shopping for a mortgage loan by contacting their local bank.

The secondary mortgage market is a market where mortgage loans and servicing rights are bought and sold by various entities.
A large percentage of newly originated mortgages are sold by the lenders, who issue them, into this secondary market, where they are packaged into mortgage-backed securities and sold to investors such as pension funds, insurance companies, and hedge funds.
Several players participate in the secondary mortgage market: mortgage originators (who create the loans), mortgage aggregators (who buy and securitize the loans), securities dealers/brokers (who sell the securitized loans), and finally, investors (who buy the securitized loans for their interest income).
The aggregator distributes thousands of similar mortgage loans in a mortgage-backed security (MBS). After an MBS has been formed, it is sold to a securities dealer. This dealer, often a Wall Street brokerage firm, further package the MBS in various ways and sell it to investors, who are often seeking income-oriented instruments. These investors don't get control of the mortgages, but they do receive the interest income from the borrowers' repayments.

A mortgage-backed security (MBS) in the secondary mortgage market, is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them. Investors in MBS receive periodic payments similar to bond coupon payments.
When an investor buys a mortgage-backed security, he is essentially lending money to home buyers. In return, the investor gets the rights to the value of the mortgage, including interest and principal payments made by the borrower.
Selling the mortgages they hold enables banks to lend mortgages to their customers with less concern over whether the borrower will be able to repay the loan. The bank acts as the middleman between MBS investors and home buyers. Typical buyers of MBS include individual investors, corporations, and institutional investors.

There are two basic types of mortgage-backed security: pass-through mortgage-backed security and collateralized mortgage obligation (CMO) in which the investors can invest.

Types of issuers - MBS may be backed or issued by entities such as the Government National Mortgage Association (Ginnie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal National Mortgage Association (Fannie Mae).

1. Pass-through MBS

The pass-through mortgage-backed security is the simplest MBS, structured as a trust. It comes with a specific maturity date, but the average life may be less than the stated maturity age.
The trust that sells pass-through MBS is taxed under the grantor trust rules, which dictates that the holders of the pass-through certificates should be taxed as the direct owners of the trust apportioned to the certificate.

In a pass-through MBS, the issuer collects monthly payments from a pool of mortgages and then passes on a proportionate share of the collected principal and interest to bondholders. A pass-through MBS generate cash flow through three sources:

  • Scheduled principal (usually fixed)
  • Scheduled interest (usually fixed)
  • Prepaid principal (usually variable depending on the actions of homeowners, as governed by prevailing interest rates)

2. Collateralized Mortgage Obligation (CMO)

Collateralized mortgage obligations comprise multiple pools of securities, also known as tranches. Each tranche comes with different maturities and priorities in the receipt of the principal and the interest.

The tranches are also given separate credit ratings. The least risky tranches offer the lowest interest rates while the riskier tranches come with higher interest rates and, thus, are generally more preferred by investors.

One mutual fund that purchases mortgage-backed securities

Mortgage-backed securities funds are mutual funds that own various commercial and/or residential MBS bonds. These funds can be passive or actively managed.

The Vanguard Mortgage Backed Securities Index ETF (Nasdaq: VMBS)is one such mutual fund that deal in the mortgage - backed securities. It seeks to follow the performance of the Barclays Capital U.S. MBS Float Adjusted Index. The index includes U.S. agency mortgage backed pass-through securities issued by entities such as the FNMA. To be eligible for inclusion in the index, aggregates must have a minimum of $250 million outstanding and a weighted average maturity of at least one year.

This Vanguard-issued fund has an asset base totaling $1.5 billion. It's considered to have a moderate risk level. Besides its notably low fees, this fund's appeal is that it is the only one with solidly AAA-rated holdings.

3)

In USA most lenders require 10-20% of the home's purchase price as a down payment from you. It is also called 'one's own contribution' by some lenders. The rest, which is 80-90% of the property value, is financed by the lender. The total financed amount also includes registration, transfer and stamp duty charges.

According to an article written in The Urban Wire, the United States’ homeownership rate has fallen compared with other developed countries. Between 1990 and 2015, 13 of the 18 countries increased their homeownership rates, while the US rate remained unchanged. Global interest rates fell, making access to homeownership easier.

However, despite the weak performance of the US homeownership rate, the pattern of homeownership by age is similar between the US and the five most-populous European countries (UK, Italy, France, Spain, Germany).

The homeownership rate peaks at 75 to 90 percent for households ages 65 to 74 in most countries. The current rate for this age group in the US is about 80 percent. Home equity is a huge source of retirement wealth in the US and in the most-populous European countries.
US homeownership rates have fallen sharply for households ages 44 and younger.

The homeownership rate is high in the Czech Republic, Finland, Ireland, Italy, Slovenia, Spain, and Sweden, countries where homeownership costs are low compared with renting.
The current US credit environment makes it difficult for anyone with less than solid credit rating to obtain a mortgage and has resulted in the loss of approximately 6.3 million mortgages between 2009 and 2015.
It is found that one of the reasons for low homeownership rates in the 44 and younger age-groups could be because of the current credit environment that makes it difficult for anyone with less than perfect credit scores to obtain a mortgage.
Public policy in OECD countries tends to favour homeownership relative to renting and other investments, via the preferential tax treatment of owner-occupied housing. For example, while mortgage interest costs are tax deductible in many OECD countries, few countries tax imputed rent and those that do often substantially under-estimate the rental value.


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