Real Estate Tips

Mortgage Risk Analysis (Part 2)

Mortgage risk is the danger of impairment of expected yield or of invested principal. It is the chance that the borrower will fail to meet the terms of the contract and that his failure to make debt service payments will reduce the yield on the investment, or that the principal of the debt will be impaired because the value of the collateral property is not sufficient to cover costs of foreclosure and the full amount of the unpaid balance of the loan.

The analysis of mortgage risk is mainly an evaluation of the defenses against loss. The borrower is the first defense. No lender wittingly makes a mortgage which he expects to have to foreclose. But there are many uncertainties in predicting the future of financial behavior of the mortgagor and thus some chance that that foreclosure will be necessary in every loan. For this reason, the lender must carefully judge the strength of the second line of defense against loss, the collateral real estate. The effectiveness of this protection will be measured by the relationship between the unpaid debt (and other accumulated obligations such as back interest) and the proceeds of the foreclosure sale when the collateral is liquidated. 

Note that mortgage risk is not a circumstance which exists only at the moment the loan is made. To the contrary, risk is present at all times during the life of the loan until it is completely extinguished by repayment.

Mortgage risk is the product of a set of relationships among borrower, property and the loan elements. The loan elements are the amount of the debt, the interest rate, the repayment plan, and the term of the loan. In relationship to one pattern of loan elements, a certain borrower might be a high risk, with another pattern, he would be low-risk borrower as for example if the amount of the debt were reduced, or the term extended so that the monthly payments would be smaller.