Main Types of Mortgage Loans

The borrower knows the fixed repayments throughout the term of the loan. The long-term fixed-rate mortgage loan has two prepayment options:

• The borrower may prepay the outstanding debt at par (100).
• The borrower may purchase the underlying bonds in the financial markets and hand them over to the mortgage bank. This is the cheapest method if the price of the bonds is below par. In practice, mortgage banks purchase the bonds on behalf of borrowers.
  
  

All long-term fixed-rate loans may be prepaid at par. Without this option, the market price of the bonds could rise well above 100 should yields decline drastically. This would make it considerably more expensive to buy the underlying bonds and the bonds would certainly be much more expensive than the borrower’s debt in nominal terms.

The option of prepaying at par also gives borrowers a higher protection against becoming technically insolvent should interest rates decline, leading to a rise in bond prices. A borrower is technically insolvent if the total mortgage debt exceeds the value of the property. Being technically insolvent is not a problem unless the borrower needs to sell the property, because the sales proceeds would not cover the mortgage debt.

The main advantage of ARMs is that interest rates are generally lower than those of fixed-rate loans when granted. However, the borrower does not know the amount of future repayments as the interest rate will change throughout the loan term following interest rate resets. The interest rate is generally reset at a frequency of 1, 3, 5 or 10 years depending on the loan terms. The interest rate is reset when the underlying bonds are replaced with new bonds. The yield of the new bonds determines the loan rate for the new period until the next interest rate reset. The lower initial loan rate should be weighed against the risk of increases during the loan term.

An ARM may be prepaid at par (100) in connection with each interest rate reset. Alternatively, the borrower may prepay the loan by purchasing the bonds on market terms.

In addition, the loan type differs from ARMs in that the interest rate depends on a reference rate, i.e., an interest rate determined by another market. The reference rate can for instance be CITA (Copenhagen Interbank Tomorrow/Next Average, CIBOR (Copenhagen Interbank Offered Rate) or Euribor (Euro Interbank Offered Rate).

Floating-rate loans can be offered with a cap on the floating interest rate. The cap ensures that the interest rate cannot exceed a certain level allowing the borrower to hedge against major increases in the interest rate. If a loan has a 6 per cent cap, the interest rate will not be higher than 6 per cent for the duration of the cap. Loans without a cap simply track the reference rate.

A floating-rate loan may be prepaid in three ways: either at an agreed price, typically 100 or 105, or like an ARM at par (100) when the underlying bonds are refinanced. Finally, the borrower may buy the underlying bonds at the market price.