Chapter 7 Mortgage Markets

True/False Questions
1. The largest category of mortgages by dollar volume is commercial mortgages.
Answer: False Page: 194 Level: Easy
2. A shared appreciation mortgage is one where the borrower must prepay the mortgage
in 15 years so that the lender may share in the appreciation by charging a higher
interest rate.
Answer: False Page: 206 Level: Easy
3. The process of mortgage securitization results in a separation between mortgage
origination and mortgage financing.
Answer: True Page: 215-216 Level: Easy
4. The secondary market for mortgages influences the accept/reject decision in originally
granting a mortgage.
Answer: True Page: 194 Level: Easy
5. Federally insured mortgages are called conventional mortgages.
Answer: False Page: 196 Level: Easy
6. The duration of a balloon payment mortgage is less than the duration of a fully
amortized 30 year fixed rate mortgage.
Answer: True Page: 196-197 Level: Medium
7. A borrower using a conventional mortgage will have to put up at least a 20% down
payment or purchase private mortgage insurance.
Answer: True Page: 196 Level: Easy
8. Discount points are paid to reduce the down payment required.
Answer: False Page: 198 Level: Easy

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9. In a growing equity mortgage the borrower pays the real rate of interest and the
principle and equity grow with inflation.
Answer: False Page: 205 Level: Easy
10. A common rule of thumb is to not refinance your mortgage unless interest rates
decline by at least 2 1/2%.
Answer: False Page: 199 Level: Easy
Multiple Choice Questions
11. Rank the following types of mortgages by amount outstanding from largest to
smallest.
I.
Home mortgages
II.
Multifamily mortgages
III.
Farm mortgages
IV.
Commercial mortgages
A)
B)
C)
D)
E)

I, II, III, IV
I, II, IV, III
II, I IV, III
IV, II, III, I
I, IV, II, III

Answer: E Page: 194 Level: Medium

12. The process of packaging and/or selling mortgages which are then used to back
publicly traded debt securities is called
A) Collateralization
B) Securitization
C) Market capitalization
D) Stock diversification
E) Mortgage globalization
Answer: B Page: 193 Level: Easy

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13. A ___________ placed against mortgaged property ensures that the property cannot be
sold (except by the lender) until the mortgage is paid off.
A) Collateral
B) Lien
C) Habeas corpus
D) Down payment
E) Writ of certiorari
Answer: B Page: 194 Level: Medium
14. If a borrower makes a 20% down payment on a conventional mortgage they will be
required to obtain
A) FHA insurance
B) VA insurance
C) Private mortgage insurance
D) GNMA payment guarantees
E) None of the above
Answer: E Page: 194 Level: Easy
15. Mortgage payments are _____ on a 15 year fixed rate mortgage than on a 30 year
fixed rate mortgage, and _____ is paid on a 15 year mortgage than on a 30 year
mortgage, ceteris paribus
A) Lower; less interest
B) Lower; less principal
C) Higher; less interest
D) Higher; more principal
E) Higher; more interest
Answer: C Page: 203 Level: Medium
16. With a fixed rate mortgage the _____ bears the interest rate risk and with an ARM the
______ bears the interest rate risk.
A) Borrower; lender
B) Borrower; borrower
C) Lender; lender
D) Lender; borrower
E) Federal government; pool organizer
Answer: D Page: 197-198 Level: Medium

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17. The schedule showing how monthly mortgage payments are split into principle and
interest is called a(an):
A) Securitization schedule
B) Balloon payment schedule
C) Graduated payment schedule
D) Amortization schedule
E) Growing equity schedule
Answer: D Page: 200 Level: Easy
18. You purchase a $200,000 house and you pay 20% down. You obtain a fixed rate
mortgage where the annual interest rate is 7% and there are 360 monthly payments.
What is the monthly payment?
A) $1,330.61
B) $1,074.49
C) $1,064.48
D) $1,327.34
E) $933.33
Answer: C Page: 201-202 Level: Medium
Rationale: 0.80*$200,000 = Pmt PVIFA(0.07/12, 360 months]
19. You obtain a $275,000, 15 year fixed rate mortgage. The annual interest rate is 5.5%.
In addition to the principle and interest paid you must pay $225 a month into an
escrow account for insurance and taxes. What is the total monthly payment (to the
nearest dollar)?
A) $2,472
B) $1,561
C) $1,786
D) $2,143
E) $1,967
Answer: A Page: 201-202 Level: Medium
Rationale: 275,000 = [Pmt PVIFA(0.055/12, 180 months)] + 225

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20. You purchase a $300,000 town home and you pay 30% down. You obtain a 30 year
fixed rate mortgage with an annual interest rate of 6%. After 5 years you refinance the
mortgage for 25 years at a 5% annual interest rate. After you refinance what is the new
monthly payment (to the nearest dollar)?
A) $1,259
B) $1,142
C) $1,093
D) $1,632
E) $1,176
Answer: B Page: 201-202 Level: Difficult
Rationale: 0.70*$300,000 = Pmt PVIFA(0.06/12, 360 months); Balance after 5 years
= 195,414; New Pmt = 195,414 / PVIFA(0.05/12,300) = 1,142.37
21. A borrower took out a 30 year fixed rate mortgage of $130,000 at an 8% annual rate.
After five years, he wishes to pay off the remaining balance. Interest rates have by
then fallen to 7%. How much must he pay to retire the mortgage (to the nearest
dollar)?
A) $134,963
B) $118,657
C) $72,766
D) $123,591
E) $114,042
Answer: D Page: 201-202 Level: Medium
Rationale: $130,000 = Pmt PVIFA(0.08/12, 360 months] ; Pmt = $953.89 ; PV =
$953.89 PVIFA(0.08/12, 300 months]
22. A homebuyer bought a house for $286,000. The buyer paid 25% down but decided to
finance closing costs of 3% of the mortgage amount. If the borrower took out a 30
year fixed rate mortgage at a 6% annual interest rate, how much interest will the
borrower pay over the life of the mortgage?
A) $255,927
B) $248,473
C) $195,491
D) $266,992
E) $235,453
Answer: A Page: 203 Level: Difficult
Rationale: 0.75*286,000*1.03 = Pmt PVIFA(0.06/12, 360 months] ; Pmt = 1,324.62;
Total interest = (360 * 1,324.62) - (0.75*286,000*1.03)

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23. A homeowner could take out a 15 year mortgage at a 6.5% annual rate on a $125,000
mortgage amount, or she could finance the purchase with a 30 year mortgage at a
7.0% annual rate. How much total interest over the entire mortgage periods could she
save by financing her home with the 15 year mortgage (to the nearest dollar)?
A) $103,387
B) $140,625
C) $92,457
D) $113,786
E) $77,899
Answer: A Page: 203 Level: Difficult
Rationale: 125,000 = Pmt PVIFA(0.065/12, 180 months] ; Pmt of 1,088.88 x 180 =
195,999 ; 125,000 = Pmt PVIFA(0.07/12, 360 months] ; Pmt of 831.63 360 =
299,386 ; 299,386 - 195,999 = 103,387
Use the following to answer questions 24-26:
A homeowner can obtain a $150,000 thirty year fixed rate mortgage at a rate of 7.5% with
zero points or at a rate of 7.0% with 2 points.
24. If you will keep the mortgage for 30 years, what is the net present value of paying the
points (to the nearest dollar)?
A) $18,313
B) $13,667
C) $7,646
D) $5,631
E) $4,646
Answer: E Page: 204 Level: Difficult
Rationale: No Points: $1,048.82= $150,000 / PVIFA(0.075/12, 360 months] ; Pay
Points: $997.95= $150,000 / PVIFA(0.07/12, 360 months] ; $1,048.82$997.95=$50.87 ; [$50.87 x PVIFA(0.07/12, 360 months)] - (0.02x150,000) =
$4,646.15

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25. How long must the owner stay in the house to make it worthwhile to pay the points if
the payment saving is invested monthly?
A) 5.40 years
B) 3.33 years
C) 6.04 years
D) 4.91 years
E) More than 30 years
Answer: C Page: 204 Level: Medium
Rationale: $3,000 points cost = $50.87 payment savings PVIFA(0.07/12, N) ; N =
72.49 months / 12 = 6.04 years
26. How long must the owner stay in the house to make it worthwhile to pay the points if
the payment saving is not invested?
A) 5.40 years
B) 3.33 years
C) 6.04 years
D) 4.91 years
E) More than 30 years
Answer: D Page: 204 Level: Medium
Rationale: $3,000 points cost / $50.87 payment savings = N = 59 months / 12 = 4.91
years
27. A _____ may be used by a borrower who wants to pay off a mortgage more quickly
than a standard mortgage.
A) Second mortgage
B) GPM
C) ARM
D) Automatic Rate Reduction Mortgage
E) GEM
Answer: E Page: 205 Level: Medium
28. A _____ is used to purchase a more expensive home than for which the borrower
could otherwise qualify.
A) Second mortgage
B) GPM
C) ARM
D) Automatic Rate Reduction Mortgage
E) GEM
Answer: B Page: 205 Level: Medium

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29. A _____ mortgage is primarily used when interest rates are high in order to allow
borrowers to obtain mortgages who could not otherwise obtain mortgages to do so.
A) SAM
B) RAM
C) GEM
D) ARM
E) Automatic Rate Reduction Mortgage
Answer: A Page: 206 Level: Medium
30. A _____ is used to help retired people receive monthly income in exchange for the
equity in their home.
A) SAM
B) Equity Participant Mortgage
C) RAM
D) PLAM
E) GEM
Answer: C Page: 206-207 Level: Medium
31. Which of the following statements about mortgage markets is/are true?
I.
Mortgage companies service more mortgages than they originate.
II.
Servicing fees typically range from 2% to 4%.
III.
Most mortgage sales are with recourse.
IV.
The government is involved in the residential mortgage markets.
A)
B)
C)
D)
E)

I, III and IV only

II, III and IV only
I, II and IV only
II and III only
I and IV only

Answer: E Page: 206-208 Level: Medium

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32. Which of the following statements about GNMA is/are true?

I.
GNMA provides timing insurance.
II.
GNMA creates pools of mortgages and issues securities.
III.
GNMA insures only FHA, VA and FmHA loans.
IV.
GNMA requires that all mortgages in the pool have the same interest rate.
A)
B)
C)
D)
E)

I, II , III and IV are true

I, III and IV only
I, II and III only
II, III and IV only
III and IV only

Answer: B Page: 209 Level: Medium

33. A $25,000 face value GNMA pass-through quote sheet lists a spread to average life of
103, PSA of 220, and a price of 101-09. This means that
I.
The pass-through yield is 103 basis points above the comparable maturity
Treasury bond
II.
The pass-through is being prepaid more quickly than standard PSA
III.
The pass-through is priced at $25,272.50
A)
B)
C)
D)
E)

I, II and III are correct

I and II only
I and III only
II and III only
III only

Answer: B Page: 211 Level: Difficult

34. The advantage of a CMO to an investor over a pass-through is
A) The CMO increases the predictability of the period over which cash flows will be
received
B) The CMO reduces credit risk
C) The CMO is not taxable and the pass-through is taxable
D) CMO rates of return are guaranteed
E) All of the above
Answer: A Page: 213-214 Level: Medium

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35. A MBB differs from a CMO or a pass-through in that

0 The MBB does not result in the removal of mortgages from the balance sheet.
1 A MBB holder has no prepayment risk.
2 Cash flows on a MBB are not directly passed through from mortgages.
A)
B)
C)
D)
E)

I, II and III
I and II only
II and III only
I and III only
I only

Answer: A Page: 214 Level: Difficult

36. One fixed rate mortgage pool has a 750 PSA and a second fixed rate pool has 150
PSA. The pool with the higher PSA ________________________ than the pool with
the lower PSA.
I.
probably has a higher coupon
0 II probably has lower default risk
1 III will mature more quickly
A)
B)
C)
D)
E)

I, II and III
I and II only
II and III only
I and III only
I only

Answer: D Page: 211 Level: Difficult

37. As compared to FRMs, ARMs result in which of the following for the lender?
0 higher interest rate risk
I.
II lower default risk
II.
III longer mortgage maturity
A)
B)
C)
D)
E)

I, II and III
I and II only
II and III only
I and III only
None of the above

Answer: E Page: 196-197 Level: Medium

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38. An equity participation mortgage is very similar to a

A) GEM
B) GPM
C) SAM
D) PLAM
E) RAM
Answer: C Page: 206 Level: Easy
39. Which one of the following types or mortgages are likely to become more popular as
the average age of the U.S. population increases?
A) GEM
B) GPM
C) SAM
D) PLA
E) RAM
Answer: E Page: 206-207 Level: Easy
40. Which one of the following entities is a government agency dealing with mortgages?
A) GNMA
B) FNMA
C) FHLMC
D) PIP
E) CMO
Answer: A Page: 209 Level: Easy

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Short Answer Questions

41. Construct an amortization schedule for the first three months and the final three
months of payments for a thirty year, 7% mortgage in the amount of $90,000. What
percentage of the 3rd payment is principle? What percentage of the final payment is
principle? What do these differences imply? (Hint: The balance after the 357th
payment is $1,775.56)
Answer:

12.46% of the 3rd payment is principle, 99.42% of the last payment is principle. In a
long term amortized loan, the early payments are almost entirely interest, and the
borrowers equity position grows only slowly at first, but over time more and more of
the payment goes to principle. Page: 202-203 Level: Difficult
42. Why do mortgage lenders prefer ARMs while many borrowers prefer fixed rate
mortgages, ceteris paribus.
Answer: With an ARM the homeowner bears the interest rate risk (not totally, because
the ARM is capped). From the lender's perspective, if deposit rates change, hopefully
the ARM rate will change and the lender's net profit will remain about the same. If
deposit rates rise, the homeowner's payments are also likely to rise, preserving at least
some of the institution's profit margin. With a fixed rate mortgage the homeowner
bears no out of pocket interest rate risk, but the lender's profit margin will normally
fall if rates rise as their fund's cost will rise but mortgage income stays the same.
Page: 196-197 Level: Easy

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Use the following to answer questions 43-44:

A homeowner is looking to buy a home in Marvin Gardens. The most he can afford to pay in
total is $1,500 per month. Yearly property taxes will probably be about $2,950 (escrowed
monthly) and insurance is $65 per month. There are no other costs.
43. If mortgage rates are 6% for a 30 year fixed rate mortgage, how large can his
mortgage be?
Answer: Max monthly payment = $1,500 - $2,900/12 - $65 = $1,189.17
PV = $1,189.17 * PVIFA(6/12, 360) = $198,343 Page: 201-202 Level: Medium
44. If his parents give him $20,000 for a down payment, what is the most he can pay on a
house with a 15 year mortgage if the interest rate is 5.25%?
Answer: $1,500 - $2,900/12 - $65 = $1,189.17
PV = $1,189.17 * PVIFA(5.25/12, 180) = $147,929 + $20,000= $167,929
Page: 201-202 Level: Medium
45. What three major ways has the federal government assisted the mortgage markets?
Explain.
Answer:
0 By providing insurance for homeowners. This assists resale and securitization
of mortgages because secondary buyers don't have to engage in credit analysis of
homeowners.
1 By sponsoring or creating pools of mortgages for securitization. This provides
a national source of funds to all regions of the economy.
2 By directly providing mortgage credit.
Page: 206-208 Level: Medium

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46. Why are FNMA and Freddie Mac sometimes considered quasi-government agencies
or government sponsored enterprises (GSEs)? Why have they both been in the news
lately? Explain.
Answer: FNMA and FHLMC (or Freddie Mac) have lines of credit with the Treasury
and most investors believe the government will not allow these large organizations to
fail even though both are technically private companies. Because of their low
perceived risk, both agencies can borrow at favorable rates, making them more
profitable than they would be otherwise and allowing them to grow more than they
could otherwise. The agencies have been in the news for excessive interest rate risk
caused by large derivatives positions, for overcharging lenders for services provided,
for accounting irregularities designed to smooth earnings and/or generate bonuses for
employees. Greenspan also stated that these institutions were a source of risk for the
economy because of their tie to government and their extensive use of debt to finance
growth. Page: 207-208, 219 Level: Medium
47. Who are the major buyers of mortgages after they have been originated? What is the
difference between selling with recourse or without recourse? Which is most
common?
Answer:
The five major buyers are:
1. Domestic banks
2. Foreign banks
3. Insurance companies
4. Pension funds
5. Closed end bank loan mutual funds
6. Nonfinancial corporations
Selling with recourse means the buyer of the mortgage can require the mortgage seller
to repay the mortgage if the homeowner defaults. A sale without recourse means the
seller has no legal liability in the event the homeowner defaults. Most sales are
without recourse. Page: 206, 208 Level: Medium
48. How does GNMA improve mortgage marketability?
Answer: GNMA sponsor pools of FHA or VA insured mortgages and provides timing
insurance to investors (ensures the timely receipt of promised cash flows in the event
of homeowner default). GNMA allows private pool organizers to issue securities
backed by the mortgage pool that bear GNMA's name. The GNMA name tells
investors there is no credit risk and that the securities are actively traded. Page: 210
Level: Medium

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49. Explain each term of the following pass-through quote:

Answer: FMAC Gold 7.0%: A pass-through issued by Freddie Mac; maximum

payment delay is 55 days. The coupon rate is 7%.
97-31 price on pass-throughs (paid monthly) is 97.9875% of par.
5.9 years average life of security based on prepayment patterns.
PSA 150 means that the mortgage holders are prepaying at a rate 50% faster than the
benchmark prepayment rate (PSA = 100) Page: 211 Level: Difficult
50. You bought your house 5 years ago and you believe you will be in the house only
about 5 more years before it gets too small for your family. Your original home value
when you bought it was $250,000, you paid 20% down and you financed closing costs
equal to 3% of the mortgage amount. The mortgage was a 30 year fixed rate mortgage
with a 6.5% annual interest rate. Rates on 30 year mortgages are now at 5% if you
pay 2 points. Your refinancing costs will be 1.5% of the new mortgage amount
(excluding points). You won't finance the points and closing costs this time. A new
down payment is not required. Should you refinance? Show your work.
Answer: Find the original payment and then find what you owe now:
0.80*250,000*1.03 = Pmt * PVIFA(6.5/12,360); Pmt = $1,302.06
Balance now = $1,302.06 * PVIFA(6.5/12,300); Balance now = $192,838.61
New payment if refinance
$192,838.61 = Pmt * PVIFA(5/12,360); Pmt = $1,035.2
Pmt savings = $1,302.06 - $1,035.2 = $266.86 per month
Refinancing costs = (2%+1.5%)*$192,838.61 = $6,749.35
Find Breakeven time:
$6,749.35 = $266.86 * PVIFA(5/12, N); N = 26.78 months = 27 months / 12 = 2.25
years. You plan on being in the house for 5 more years, so it is worthwhile to
refinance. Page: 204 Level: Difficult
51. Why were CMOs created?
Answer: Some investors desired more protection from prepayment risk than offered by
pass-throughs. The creation of different payment tranches in a CMO allows the
investor to better tailor their prepayment risk exposure.
Page: 213-214 Level: Medium

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