A mortgage loan is a loan used to finance a real estate property which is in turn used as collateral for the loan. The lender has a right to foreclosure by selling off the property. Typically, the borrower is required to pay a certain down payment and as he pays off the loan his equity changes. When the down payment is high, the loan to value (LTV) ratio is low which means that there is a lower probability of default.
Prime loans vs non-prime loans
In the US, mortgages are categorized either as prime loans or subprime loans. A loan is a prime loan if the borrower has high credit quality as evident from strong employment and credit histories, sufficient income and substantial equity, otherwise, it is sub-prime.
Mortgage loan structures vary depending on the maturity, determination of interest rate (also called mortgage rate, contract rate or note rate), principal repayment, prepayment option and terms of foreclosure:
Maturity refers to the number of years till maturity, which ranges from 15-30 (in the US), up to 40 (in Europe) and up to 100 (in Japan).
Interest rate determination
Interest rates on a mortgage are either fixed, adjustable/variable, the initial period fixed and convertible:
Fixed mortgage loans
These pay a fixed interest rate. They are predominant in the US.
On the adjustable/variable mortgages, the interest rate is reset periodically often specifying the maximum change at any given reset date and maximum interest rate possible, in line with a change in some benchmark rate (indexed-referenced ARM) or at the discretion of the lender (reviewable ARM).
The initial period fixed rate mortgages
These pay a fixed rate for an initial period, after which it is adjusted, either as a new fixed-rate (in a rollover/renegotiable mortgage) or as an adjustable-rate (in a hybrid mortgage).
A convertible mortgage is a mortgage that can be converted from fixed to adjustable and vice versa at some point.
Most mortgages are amortizing in nature i.e. periodic payments are a combination of interest and principal. In a fully-amortizing mortgage, all principal is paid off through periodic payments while in a partially amortizing mortgage, a balloon payment is also needed. Some mortgages, called interest-only mortgages pay no principal repayment during a certain time period. If no principal is repaid over the whole life of the mortgage, they are called interest-only lifetime mortgages or bullet mortgages.
Prepayment option and prepayment penalties
A prepayment option (also called early repayment option) allows borrowers to pay off the mortgage principal before its due. This affects the lender because he receives cash typically when the interest rates are low. This is why many mortgages stipulate penalties on prepayment within a stipulated time of loan origination (which may extend to the whole term of the loan), an extreme case is when the borrower has to pay any difference between the contract rate and current rate to the lender.
Rights of the lender in foreclosure: recourse loan vs non-recourse loan
In a recourse loan (which are common in Europe), a lender is entitled to recover any shortfall that exists between loan amount and proceeds from disposal from the borrower; but not in a non-recourse loan (which are common in the US). The distinction is important because when a loan is non-resource, some borrowers in an underwater mortgage (a mortgage in which loan exceeds property value) may choose to default deliberately in which is called a strategic default.