Mortgage Risk Analysis (Part 1)
When an application for a mortgage loan is received by a financial institution, the mortgage loan officer or committee must decide upon its acceptability. It is usually assumed that the prospective borrower will pay the going rate of interest and that the mortgage loan will be repaid or amortized within some maximum term of years which represent the current policy of the lender.
The mortgage loan officer is confronted with the problem of determining the acceptability of the mortgage investment under these conditions; or if it is not acceptable under the customary mortgage contract, he may propose modifications in the terms, such as a higher interest rate or faster amortization, which might make it a good investment. Of course, he may conclude that it does not meet minimum standards, even with adjustments in terms. The basic analytical problem of the lender is the evaluation of mortgage risk.
The objectives of the mortgage lenders are to make a loan which will produce a gross return sufficient to:
1- Cover the costs of making and servicing the loan
2- Provide a basic or pure interest return on the capital, and
3- Yield a sufficient reward for risk taking. The cost can be estimated with reasonable accuracy; the basic interest rate is a product of current money market conditions; but the degree of risk inherent in the mortgage investment situation is dependent on a complex of financial and real estate factors.
The problems of evaluating mortgage risk are the most critical as well as the most difficult which confront the lender in selecting mortgage loans for investment.
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