What Are Mortgage Bonds And How Do They Work?
When a borrower closes on a mortgage, their lender is likely to sell their home loan in a group of other mortgages. These mortgages are then packaged and sold as investments in the form of bonds on the secondary mortgage market.
This happens because lenders need to liquidate the mortgages they hold so they can finance future mortgages. The mortgages sold as mortgage bonds are a type of mortgage-backed security (MBS) and are secured by residential (versus commercial) property.
What Is A Mortgage Bond?
Mortgage bonds are investment products traded on the open market and secured by residential real estate as collateral. Mortgage lenders group home loans and sell them to third parties like government-sponsored enterprises (GSEs).
These third parties package the loans to sell to investors, this process is called securitization. Essentially, mortgage bonds are a pool of mortgages, backed by real estate and real property, that are available as investments on the secondary mortgage market.
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How Do Mortgage Bonds Work?
When a home sale is completed, the mortgage originator will typically sell the mortgage to an investment bank or GSE.
The sale of your mortgage takes place shortly after you close on a home loan. When mortgages are purchased, theyare bundled and become mortgage bonds. The shares of these bonds are then sold to investors on the secondary market.
Mortgage bonds are generally considered a safe investment because they’re secured by real property. In other words, if a homeowner defaults on the loan or is unable to make payments, the property can be sold to recover the debt. The ability to sell property in exchange for cash makes mortgage bonds a low-risk investment.
What Is A Government-Sponsored Enterprise?
A government-sponsored enterprise (GSE) is a financial services corporation created by the United States government. GSEs like Fannie Mae and Freddie Mac play a large role in supporting the housing market and making mortgage funding available for borrowers.
The mission of a government-sponsored enterprise is to encourage homeownership and ensure liquidity in the housing market. They do this by creating and enhancing cash flow to specific sectors of the economy.
How Do GSEs Support Mortgage Bonds?
Fannie Mae and Freddie Mac help the real estate market be more efficient and transparent by setting loan limits and ensuring best practices. Created by Congress, Freddie and Fannie are two GSEs that actually buy mortgages from mortgage lenders and package them into MBS.
The U.S. government’s involvement and regulations reduce risk for investors who buy shares of mortgage bonds. GSEs help investors and homeowners invest in real estate safely and securely.
In real estate, government-sponsored enterprises guarantee qualified mortgages. This implicit guarantee from the government helps ensure that the investments won’t be allowed to fail. Ultimately, this makes mortgage bonds lessrisky and ultimately more attractive to investors.
Who Buys Mortgage Bonds?
Mortgage bonds have very little risk because they’re backed by the U.S. federal government. Investors seek safe and reliable income like mortgage bonds and mortgage-backed securities. This is because of the steady stream of interest payments made by homeowners.
Investors Seeking Safety
Overall, mortgage bonds are considered safer than most corporate bonds because the debt is secured by real property. This means that in the event of a foreclosure, the property securing the bond is sold to pay off the debt.Investors might even prefer mortgage bonds over other secure investments, like U.S. Treasury bonds which are widely considered safe and reliable.
When an investor wants to diversify their portfolio, real estate investments are a popular choice. Mortgage-backed securities have historically provided yields due to their cash flows and liquidity. They’re also easy to diversify geographically. For example, if the housing market in one state was falling, an MBS can help to alleviate the risk by purchasing mortgages from around the country.
Investors Seeking Reliable Income
When you take out a mortgage, you pay both principal and interest on the loan. The interest paid by homeowners to mortgage services throughout the life of their mortgages becomes income to the investors who purchased mortgage-backed securities.
If mortgagees didn’t have to pay the principal and interest on their homes, then MBS wouldn’t be as attractive investments. With a mortgage bond, real estate investors receive monthly interest payments and often see growth in the value of their portfolios over time.
Their monthly returns consist of both interest and principal, but the amount they receive can vary each month. The amount of interest they receive is dependent on the amount of principal in the mortgage pool.
Pros And Cons Of Mortgage Bonds
Now that you know the basics, let’s take a look at some of the pros and cons of mortgage bonds.
Pros
- Comparatively safe: All investments have risks, but mortgage bonds are considered a fairly safe investment. This is because if the homeowner defaults, the investor is protected because mortgages are collateral loans.
- Help generate more mortgages: Mortgage-backed securities help banks liquidate parts of their loan portfolios. This means they have money available to offer loans to new borrowers.
- Dependable: Mortgage bonds generally pay monthly returns. This means you can reinvest your profits and continue to grow your investments.
Cons
- Lower yield: Though mortgage bonds are profitable, they generally have lower yields than corporate bonds.
- Low returns: Although unlikely, a mortgage bond can lose money. For example, prepayments and extensions from borrowers can make mortgage bonds less profitable. Additionally, if inflation rates are high bondholders might not make enough interest to turn a profit.
The Bottom Line
Once you close on your home, your mortgage will likely be sold and packaged as a mortgage bond or MBS. This sale is normal and won’t have an impact on your mortgage payments or term.
Mortgage bonds and other MBSs allow lenders to free up resources so lenders can continue to finance loans to new home buyers. Mortgage bonds help keep the mortgage industry moving. They’re also attractive investment opportunities that can help diversify your portfolio.
Learn more about the different types of real estate investing that could be right for you.
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