Lesson 2 of 5 · 14 min
Residential mortgage loans
A mortgage is a loan secured by property, and four features decide how risky it is for whoever ends up holding it: how much equity the borrower has (LTV), how stretched their income is (DTI), whether they can prepay, and whether the lender can chase them beyond the house (recourse).
In short
- A mortgage loan is secured by a specific property. The lender has a first lien and can foreclose, take the property and sell it if the borrower does not pay.
- Loan-to-value ratio (LTV) = loan / property value. Lower LTV → more borrower equity → lower default risk and more protection for the lender. LTV changes over time.
- Debt-to-income ratio (DTI) = monthly debt payments / monthly gross pre-tax income. Lenders want it low.
- Prime borrowers: strong credit, low DTI, plenty of equity, first lien. Subprime: weaker credit, high DTI and/or high LTV, or second liens.
- The borrower's prepayment option makes cash flows uncertain; prepayment penalties (common in Europe, rare in the US) reduce the incentive to prepay.
- Recourse lets the lender claim a foreclosure shortfall from the borrower; non-recourse limits the lender to the property, making strategic default on an underwater loan more likely.
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