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Borrower’s risk is defined as the type of risk that borrowers of any financial funds such as loans or mortgages are exposed to when they borrow either large or small amounts of money. Borrower’s risk mostly occurs when an individual borrows money against property or assets that have a high property value.
If the borrower defaults in his unsecured loan repayment, the lender of the loan has the right to force the borrower to sell his property. Borrowers risk is also the type of risk that is presented by low or high interest rates on borrowed funds which might make it difficult for the borrower to repay their loan (Strahan 1).
Residential mortgage lending refers to a type of secured loan borrowed against real property and is usually acquired through the use of a mortgage note. The mortgage note is meant to highlight the existence of the loan when granting a mortgage which will secure the loan for the borrower (Dorsey and Rockwell 44).
Individuals who want to own or build their homes usually obtain financing through residential mortgage lending which can be obtained through a loan. These loans are usually purchased or secured against the property from a financial institution such as a bank or mortgage lending institution.
In many countries around the world, individuals who want to build or buy their own homes are usually funded by mortgage loans. There is a small potion on people who have enough savings or liquidated funds which they can use to buy property or build their own houses.
Residential mortgage lending provides such individuals with the appropriate amount of funds that they can use to build their own houses or buy their own property. The main sources of residential mortgage lending that are used in the primary market include commercial banks, savings and loans associations, credit unions and mortgage companies (Dorsey and Rockwell 44).
Factors Determining Borrower Risk
One major factor that affects the borrower’s risk is the interest rates that are charged on borrowed money that has been lent by either a commercial bank, mortgage lending company or any other lending institution.
Interest rates are basically defined as the costs that are associated with using the banks money because there is the risk that the borrower will not repay the money in the established time schedule for loan repayments. The lending institutions therefore charge interest to compensate for this risk and these interest rates are usually determined by a variety of factors such as monetary policies and inflation (O’Hara 548).
Monetary policies are established by local governing banking bodies to guide the procedures that will be used by the Federal Reserve Bank to minimize the impact of money supply and demand on interest rates. The United States Federal Reserve Bank usually sets the interest rates that will be used by banks to borrow reserves.
Any changes in the monetary policy affect interest rates in the financial market where in the event the Federal Reserve reduces the rates charged on borrowed funds, the interest rates charged on loans will reduce. Inflation affects interest rates where any increases in price commodities within the global market affects the amount of interest that will be charged on borrowed funds (Hamel 1).
Interest rates determine the borrowers risk because they present a considerable amount of risk to lenders of financial funds. In the event the lender decides to charge a high or low interest rate, the borrower’s risk will be affected as it will determine the kind of borrowing options that the borrower has in accessing financial funds.
High credit scores usually result in lower interest rates for borrowing funds while low credit scores lead to higher interest rates which mean that the borrowers risk will be determined by how they pay off their borrowed funds. If the borrower pays off their debts at the end of every month, they will have a low overall amount of debt which increases the overall credit score of the borrower thereby reducing the interest rates allocated to the borrower (O’Hara 549).
Connection linking Borrower’s risk and housing mortgage lending
Mortgage loans are usually structured as long-term loans because of the periodic payments that the borrower has to make on the mortgage which is similar to that of an annuity. Mortgage loans are usually calculated to reflect a repayment period of between ten to thirty years within which time the borrower is meant to complete their payments.
Lenders usually provide funds to borrowers against the property so that they can be able to earn an interest income and basically borrow these funds. Mortgage is generally the security interest the lender has on the property that the borrower wants to buy or build.
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Mortgages usually place restrictions on the borrower with regards to the use or disposal of the property which means that the borrower cannot be able to sell off the property without completing their loan repayment to the lending company (Jacobs and Anseimo 15).
Chiang et al (5) conducted a study on the mortgage banking environment in Hon Kong by focusing on how the mortgage rates in the country differed with the various individual borrowers in the country.
The researchers focused on loan information, property and borrower characteristics in their study to determine the relationship that existed between residential mortgage lending and borrower’s risk. Based on the results of their study, Chiang et al (6) were able to note that the mortgage rates charged for borrowed funds in Hong Kong differed with the type of individual borrower who was trying to access funds from the lending institutions.
The individual borrower’s risk affected residential mortgage lending rates when credit sorting was done based on whether the borrower had a prepayment risk or a default risk on the loan.
The prepayment risk on mortgage rates was mostly charged to borrowers who were able to make an early unscheduled return of principal on their fixed income security while the default risk was charged to borrowers who defaulted in their loan repayments (Retsinas 279).
With regards to loan information, Chiang et al (5) noted that the type of loan taken by the borrower depended on the type of risks which accompanied the loan. As mentioned earlier on in the discussion, the authors were able to observe that the individual characteristics of the borrower determined the type of credit sorting that would be done on the prepayment and default risks.
These two risks were mostly common in loans that had high collateral which means that a higher mortgage rate would be charged on the loan.
The borrower who decided to pursue this type of loan would have a slower prepayment of the loan meaning that the type of risk they have selected is the prepayment risk. If borrowers choose a loan with lower collateral they would have a higher prepayment exposing them to the default risk (Chiang et al 7).
From the analysis, the researchers were able to establish a relationship between residential mortgage lending and the borrower’s risk when acquiring financial funds for home ownership.
Chiang et al’s study on residential mortgage lending and borrower’s risk was conducted before the global financial crisis of 2008 to 2009 meaning that their discussion was not able to factor in the changes that took place in financial lending, mortgage rates and the value of real estate in most of the affected countries around the world.
The researchers mostly focused their study on a large data set of mortgages from the time mortgage insurance was introduced to the world in 1997. During the financial crisis that began in 2007, mortgages issued to subprime borrowers began to decline after the value of real estate shoot up in the United States (Kolb 170).
Majority of the mortgages that had been issued to the subprime borrowers were adjustable rate mortgages which began to reset themselves at higher interest rates once the value of property shot up. This had a negative effect on the securities that were used to back the adjustable rate mortgages which had mostly been held by financial lending firms such as banks and mortgage lending companies (Russo and Katzel 6).
Borrowers who demonstrated a high risk in borrowing funds added fuel to the crisis because of their borrowing practices which lead to the decline of the subprime mortgages.
The risky loan options that lenders offered to these high risk borrowers fuelled the financial crisis even further because there were no down payments made on property. This demonstrated the type of negative relationship that existed between residential mortgage lending and borrowers risk during the financial meltdown (Oxford Business Group 64).
Recommendations and Conclusion
The information gained from this research is useful especially for entrepreneurs and individuals who want to purchase or build their own property as it will help them to determine the type of borrower’s risk they should adopt when paying off their mortgages.
The borrower should study the interest rates charged on loans and mortgages to determine the type of risk that they will pursue when they borrow funds from the lending institutions. Borrowers should also consider the value of property to ascertain the mortgage rates that will be charged on real estate.
Chiang, Raymond C. Ying-Foon Chow and Ming Liu. Residential mortgage lending and borrower risk: the relationship between mortgage spreads and individual characteristics. The Journal of Real Estate Finance and Economics, 25.1(2002): 5-32
Dorsey, Megan and Rockwell, David. Financing residential real estate. New Jersey: Rockwell Publishing Company, 2005. Print
Hamel, Gregory. What factors change interest rates? 9 January 2011. Web.
Jacobs, Myles and Anseimo, Thomas. Residential real estate 2008 edition. Illinois: Illinois Institute for Continuing Legal Education, 2008. Print
Kolb, Robert W. Lessons from the financial crisis. New Jersey: John Wiley and Sons, 2010. Print
O’Hara, Phillip Anthony. Encyclopedia of political economy. London: Routledge, 2001. Print
Oxford Business Group. The report: Abu Dhabi 2009. Oxford, UK: Oxford Publishers, 2010. Print
Retsinas, Nicolas. Low-income homeownership: examining the unexamined goal. Washington: The Brookings Institution, 2002. Print
Russo, Thomas and Katzel, Aaron. The 2008 financial crisis and its aftermath: confronting the next debt challenge. New York: American International Group, 2010. Print
Strahan, Philip. Borrower risk and the price and non-price terms of bank loans. October 2009. Web.