If you’re planning to buy a house or to make a secure investment, you probably will come across mortgages and mortgage-backed securities. What are these, what’s the difference between them and which one do you need? Let’s discuss.
Applying for a mortgage can take up a sizeable amount of your income. On the other hand, mortgage-backed security, though generally a secure option for investors, can prove risky if the mortgage is not substantial and stable.
Mortgage: Simple Definition
A mortgage is simply a loan that is taken from a bank or other financial institution when purchasing a house. As with any loan, a mortgage involves a principal, an interest rate and the collateral. Collateral is simply an asset that the lender uses as security for the loan. The collateral ensures that in case the borrower is unable to pay back the loan, the lender may use the collateral to make up for it.
In the case of a mortgage, the collateral is the house for which the mortgage is being taken out. If the borrower is unable to make his debt payments on time, then, subject to certain conditions, the lender may sell the house and keep the money in lieu of the loan amount. The principal is the amount of money the buyer is taking as the loan for mortgaging his house. For example, a lender may take a mortgage that covers a hundred per cent of the cost of his or her house. Then, the entire cost of the house acts as the principal for the mortgage.
The interest rate is the cost of taking out the mortgage. Simply put, it is the money the lender charges the borrower for his or her services in helping the borrower buy the house. It is an extra amount that the borrower has to pay back to the lender as the debt is paid off.
Mortgage-Backed Security: Simple Definition
Any good or asset that can be used in exchange for another similar good or asset, or can be traded to raise capital is defined as a security. For example, a sum of money, a car, a house, stocks for a company or ownership shares all come under securities.
Now, a mortgage-backed security, or MBS, is a group or pool of mortgage loans that are bundled together and then sold to investors. An MBS falls under the category of an asset-backed security ie a tool or financial instrument that is secured by a good or asset. A lender, for example, a bank, can pool together similar loans, or mortgages in the case of an MBS, and then sell them off to investors to make more money for lending out to more people. The investors get periodic payments from the borrowers of the loan that the lender may otherwise have received.
What Is The Difference Between A Mortgage And A Mortgage-Backed Security?
The primary difference between a mortgage and a mortgage-backed security is how they function and their utilisation. A mortgage is a loan given to a homeowner or business that wants to buy a property. It is generally a long-term loan that the borrower pays back over a certain amount of time topped with interest. It is a debt instrument ie borrowers can use it to raise money for a purchase, in this case, a house. A mortgage is a bond that states that a certain entity (the homeowner or business) owns a lender a certain amount of money to be paid back over a certain period of time with interest. In case they default, the lender gets to keep the house or property as collateral.
Mortgage-backed securities, on the other hand, form a secure investment for investors while at the same time raising capital for the original mortgage lenders to lend out money to potential homeowners. It is a type of asset-backed security and not a bond. It is primarily a contract between the mortgage owners or mortgage lenders and investors. Moreover, it provides a steady stream of cash flows to the investors who bought the mortgage-backed security. The bank or mortgage lender generates capital for lending out to more home buyers by selling its pool of mortgages to investors.
Mortgage-Backed Securities Example
How do mortgage-backed securities work? How are they created and how do they benefit the concerned parties?
Let’s say a person A wants to buy a house but doesn’t have the money for it. A goes to lender B, say the bank that will lend him the capital for the house. This capital becomes the mortgage. A agrees to pay back the mortgage over a 30 year period with interest. Bank B starts to get steady cash flows from A.
Now, bank B is being approached by a lot of people interested in buying houses. And it starts to give out loans to these people. To ensure that it has enough money to give as mortgages, B pools all similar mortgages together and seels them to an investor in the open market. This pool of mortgages that are used to raise capital for bank B is known as a mortgage-backed security. This is how a mortgage-backed security is essentially created.
MBSs benefit both the bank and the investor. The bank gets to raise money for more mortgages in the future. The investors get periodic payments from the homeowners as they make payments on their mortgage, as now the investor owns their mortgage.
Residential Mortgage-Backed Securities
Residential mortgage-backed securities are a type of debt-based security created by pooling together thousands of home loans. These loans are financed by the interest rate on them, which is usually high since the demand for purchasing houses is high.
The pool of mortgages is divided into tranches or classes of RMBS transactions. The tranches are divided based on their interest rate and principal. An investor can choose which tranche to invest in while purchasing an RMBS.
Mortgage-Backed Securities Index
An index is basically a benchmark or measure of performance of an asset or group of assets. Indexes help to track the changes in the value of an asset and are used by investors to make financially smart decisions.
Some of the famous MBS indexes include:
- Barclays U.S. MBS Index
- The Vanguard Mortgage-Backed Securities Index ETF
- S&P U.S. Mortgage-Backed Securities Index
In general, if you are looking to invest your money in steady, interest backed cash flows, you should consider mortgage-backed securities. However, be careful in which MBS you invest in, as subprime mortgages tend to get risky for the investor. Consult a broker or investing form to make an informed decision.