Question

Spongebob Squarepants is making plans to buy a new home, and since he doesn't have enough money saved he has to take out a mortgage. For things in life, he ends up visiting the bank where you work and asking about mortgage loans.

a. What suits him best, asking for a 15-year or 30-year loan? Explain an advantage and a disadvantage of taking out a 30-year loan.

b. Does Spongebob have a suitable profile to obtain a mortgage loan? (If you don't know anything about him, what information do you need to answer that question?). Justify your answer.

c. Which suits him best, a fixed-rate loan, or a balloon-adjustable or adjustable-rate loan? Justify your answer.

d. What is mortgage-backed security?

e. If we give Spongebob a home loan, could that loan be used in a mortgage-backed securities issue? Does it have to be FHA insured or is it not required? Explain your answer

Answer 1

Well, I am assuming that he is an employee of a small private firm with little saving thats why he is planning to visit a bank for purchasing a new home.

a) Well i think he should take the 30year loan ,

Advantages: because the time duration is long so he only want to pay a low monthly installments , which would be affordable for an emplyee.

Disadvantages: He want to spent a specific amount on every month for 30years in order to completely pay off his loan and also the interest paid will be high than the 15year tenure.

b) Well, yes he is eligible for a mortagage loan because he is a fixed employee of that hypothetical private firm for 5 years. therefore he is availing a fixed salary everyone. Matter of fact is how much amount he will get as loan because most of banks calcualate the loan amount by multiplying 4 times the annual salary however it may vary depend upon the bank.

c) I think fixed rate loan suits him best , since he is getting his monthly income without delay and doesnot have a second source of income fixed rate lnterest will be most apted one. Fluctuating interest rates are risky, makes him trouble, if the loans gets a higher interest rates.

d) Mortgage backed securities :

Well actually this is similar to a bond because,

In simple way it can be said that, banks pay loans and will collect home loan documents from the customers and make it as a bundle of home loans  and the banks invites investments for the same from investors. Any investor who are ready to acquire the bundle of homeloans has to pay the amount which is as equal as loan amount to the banks. Therfore, that investor will be eligible to get the loan installments of customers to his account through the bank, like a bond coupon payments. These are called asset backed securities.

e) NO. Home loan of spongebob cannot be used for mortgage backed securities because he is not financially stable and any problem with his job makes him a incomeless person. So banks cannot trust these customers.

However, there was a real situation happened at the time of great recession where the main problem was making unstable loans as stable ones and make that as a bundle and sold to investment bankers, default of several payments started the economy to crash.