What is a Mortgage Instruments?

Mortgage instruments are simply securities against a mortgaged property that secure the mortgages payments.

It can act as a first or second lien against the loan or lending.

Types of Mortgage Instruments

A wide variety of mortgage instruments design has been created to meet the varying needs of borrowers and lenders.

In general, there is no one ideal mortgage instrument for a market, although as explained below there are clearly instruments that are not appropriate for some markets or types of lenders and borrowers.

A robust mortgage market will have a variety of instruments that can be tailored to the varying needs of borrowers and lenders.

What are the desirable attributes of a mortgage instrument from a borrower’s and a lender’s perspective?

A borrower is interested in the affordability of the loan, both at inception and over its life.

The lender is interested in getting an acceptable risk-adjusted rate of return over the life of the loan.

This presents a conundrum—often an attempt to improve the attractiveness of the loan for the borrower or lender creates a problem for the other party.

For example, an interest-rate cap on an adjustable-rate mortgage (ARM) reduces the potential payment shock and default risk for borrowers but can reduce the yield of the loan for lenders.

Perhaps the most important parameter in mortgage instruments design is the determination of the periodic interest rate.

The critical factor is the level of inflation in the economy.

Inflation creates problems for housing finance as it increases the level of interest rates (to compensate for expected future price increases) and their variability.

Fixed-rate mortgages (FRMs) are most suitable for low to moderate and stable inflation and interest-rate environments.

In such environments, the premiums for expected inflation and its variability are relatively low and stable. In higher and more volatile inflation environments, FRMs become either prohibitively expensive or too risky for lenders to offer.

There are some notable examples of spectacular failures for lenders offering FRMs in high inflation environments.

In the early 1980s, Mexican banks were required to use FRMs at rates set by the government. An inflation spike following currency devaluation bankrupted the banks and led to their nationalization.

Also read: International Experience with Macroprudential Mortgage Product Instruments