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Balloon Payment Mortgages Explained

A balloon-payment mortgage requires a large lump sum payment at the end of a loan term, which financial institutions prefer due to lower interest rate risk and the ability to offer reduced payments initially. Mortgage companies focus on servicing rather than investing in mortgages, exposing them to interest rate risk during the origination-to-sale period. Subprime mortgages target individuals with poor credit, allowing mortgage companies to expand their business by charging higher fees and interest rates, while mortgage rates are positively correlated with long-term government security rates, affecting lenders' revenue and risk management strategies.

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Hannah Gallano
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11 views2 pages

Balloon Payment Mortgages Explained

A balloon-payment mortgage requires a large lump sum payment at the end of a loan term, which financial institutions prefer due to lower interest rate risk and the ability to offer reduced payments initially. Mortgage companies focus on servicing rather than investing in mortgages, exposing them to interest rate risk during the origination-to-sale period. Subprime mortgages target individuals with poor credit, allowing mortgage companies to expand their business by charging higher fees and interest rates, while mortgage rates are positively correlated with long-term government security rates, affecting lenders' revenue and risk management strategies.

Uploaded by

Hannah Gallano
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

Assignment: Answer the following questions: 

1. Explain the use of a balloon-payment mortgage. Explain why a financial institution

prefer to offer this type of mortgage?

The "balloon-payment mortgage" is a lump sum paid at the end of a loan's term that is

significantly larger than all of the payments made before it. The financial institution prefers to

offer this because the balloon payment mortgage requires interest payments for a 3-5-year

period. At the end of the period, full payment is required. Financial institutions may

desire balloon mortgages because the interest rate risk is lower than for longer term, fixed-

rate mortgages also allow borrowers to reduce that fixed payment amount in exchange for

making a larger payment at the end of the loan's term. In general, these loans are good

for borrowers who have excellent credit and a substantial income.

2. Explain how a mortgage company’s degree of exposure to interest rate risk differs

from that of other financial institutions. 

Mortgage companies concentrate on servicing mortgages rather than investing in

mortgages. Thus, they are not as concerned about hedging mortgages over the long run.

However, they are exposed to interest rate risk during the period from when they originate

mortgages until they sell them. If interest rates change over this period, the price at which they

can sell the mortgages will change.


3. Explain subprime mortgages. Why were mortgage companies aggressively offering

subprime mortgages? 

A subprime mortgage is a type of loan granted to individuals with poor credit scores—

640 or less, and often below 600—who, as a result of their deficient credit histories, would not

be able to qualify for conventional mortgages. Subprime mortgages were provided by mortgage

companies to borrowers who would not have qualified for prime loans. These mortgages

enabled more people with relatively lower income, high existing debt, or a small down payment

to purchase homes. Many financial institutions such as mortgage companies were willing to

provide subprime loans because it allowed them a way to expand their business. They could

also charge higher fees and higher interest rates on the mortgage in order to compensate for

the risk of default.

4. What is the general relationship between mortgage rates and long-term government

security rates? Explain how mortgage lenders can be affected by interest rate

movements. Also explain how they can insulate against interest rate movements.

There is a high positive correlation between mortgage rates and long-term gov't security

rates. Mortgage lenders that provide fixed-rate mortgages could be adversely affected by rising

interest rates because their cost of financing the mortgages would increase while the interest

revenue received would be unchanged. The lenders could reduce their exposure to interest rate

risk by offering adjustable-rate mortgages, so that the revenue received from mortgages could

change in the same direction as the cost of financing as interest rates change

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