Identifying Mortgage Risk

Mortgage risk is simply the risk associated with a mortgage loan agreement. The most obvious risk is the risk posed to the lender that the borrower will default, but this is only one potential risk facing lenders and borrowers when a mortgage is issued. Before entering a mortgage contract, it is important to consider the wide array of risks this large loan presents to both parties. 

Risks to the Lender

  • Late payments--All lenders are also borrowers. They take loans from other institutions and people in order to make new loans. For example, when a bank issues a CD, it is borrowing money from the individual holding the CD and paying back an interest rate. It uses this borrowed money to extend loans, but it also has its own loan to repay. If a borrower is late with payments, a lender may in turn have difficulty making a loan payment. 
  • Default--A lender takes a gamble with every loan, and it bets the borrower will repay the debt. If this does not happen, the money the borrower fails to pay is written off as a loss to the lender. To reduce the risk of this occurring, lenders carefully evaluate a borrower's credit report and ability to pay the debt before issuing a mortgage. However, circumstances do change, and a borrower can end up defaulting even if he or she has an excellent payment record.
  • Foreclosure expenses--In the case of a mortgage, the risk of default is exacerbated because of foreclosure costs. The lender will have to sell the property to at least partially recover from loss. In the meantime, the cost of maintaining the home and listing it for sale falls on the lender.

Risks to the Borrower

  • Financing costs--The greatest risk to a borrower is taking a loan with high financing costs. The higher the interest rate and additional fees on a mortgage, the harder it will be for a borrower to make payments and build equity in the home. If a borrower fails to shop around for the best price, even a small percentage point difference on a mortgage interest rate can result in tens of thousands of lost dollars over time. A borrower has to be very careful to choose the timing and location of his or her loan wisely. In doing so, a borrower can reduce the risk that he or she will be paying too much for the loan itself.
  • Financial loss--A house is an investment. Ideally, a mortgage borrower wants to use the loan to build equity in a property and then sell that property for a profit in the future. With the wrong loan, though, even a good investment can turn into a financial loss quickly. For example, an interest-only loan means the borrower will not build equity in a home. If the borrower is forced to sell the home for a low price when he or she still has a large outstanding balance on the mortgage, the entire investment can be quickly lost.
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