Have you ever wondered how banks make money from home loans and why investors are interested in the housing market? The answer lies in mortgage-backed securities. While this may sound complicated, understanding it will help you see how mortgage-backed securities benefit both banks and investors. Before we dive in, do you know what mortgage-backed securities are? If not, keep reading. This blog will cover everything you need to know about Mortgage Backed Securities.
You can think of MBS as a bundle of mortgages. When a bank groups these mortgages together and sells shares of the bundle, it is referred to as mortgage-backed securities. If this still seems confusing or complicated, stay with us. This detailed guide will provide the simplest explanation of MBS.
What is a Mortgage Backed Securities?
A mortgage-backed security is a type of investment created by bundling multiple mortgages and selling shares of that bundle to investors.
Let’s understand this with a simple example: imagine a basket of fruits where each fruit represents a home loan. Instead of buying a single fruit, you buy a share of the entire basket. This means that rather than owning one fruit, you own a portion of what the basket produces. Same in MBS, investors earn money from mortgage payments without owning the home.
How do Mortgage Backed Securities work?
Let’s see the step-by-step process of how mortgage-backed securities work:
- Homeowners take out a mortgage from the bank to buy houses
- Banks make a bundle of all mortgages together into a single pool
- The banks sell shares of this pool to investors
- When homeowners make a monthly payment that includes principal and interest
- Investor get a portion of this payment according to their investment
Through this process, banks receive quick cash to issue more loans, and it does not negatively affect investors.
What are the Types of Mortgage Backed Securities?
Majorly, Mortgage Backed Securities are of two types:
Pass Through Securities
In pass-through securities, when homeowners make their monthly mortgage payments, the money flows directly to investors. This is one of the simplest forms of MBS, and investors receive regular monthly payments.
Collateralized Mortgage Obligations (CMOs)
CMOs are more complex than pass-through securities. In collateralized mortgage obligations, payments are divided into different classes, each with its own risk and return. This allows investors to choose a class that matches their preferred risk level.
Why Banks Create Mortgage Backed Securities?
Now, people have also questioned why banks need to create MBS. So, let’s see:
Free Up Cash: By selling mortgages to investors, banks can earn more money and issue more loans.
Spread Risk: All mortgage payments in one place can be too risky, which is why banks spread their risk with investors.
Encourage Investment: MBS allows investors to earn a stable income without owning any property. It also encourages more people to invest, enabling banks to issue more loans.312657
How are Mortgage Backed Securities Beneficial?
MBS are beneficial in many ways, such as:
Stable Cash Flow: Mortgage-backed securities provide investors with regular and predictable income. As homeowners make their monthly payments, investors receive both interest and principal payments. These payments remain stable even during uncertain market conditions.
Diversification: Adding MBS to your investment portfolio can help improve diversification, as they behave differently from stocks, corporate bonds, and other traditional assets. Here are some benefits of this diversification:
- Reduce overall portfolio risk
- Stabilize return
- Balancing out stock heavy
Access to Real Estate Return: Many investors are interested in real estate but do not want to own physical property. MBS is ideal for these investors, as it provides exposure to mortgage payments without the need to buy a house.
Liquidity: Mortgage-backed securities offer liquidity in selling and buying, whereas physical properties are often difficult to sell quickly. Investor gets:
- Easy Entry & Exit
- Ability to Adjust Portfolio Quickly
- Faster Access to Cash
What Tips Should You Consider While Investing in Mortgage Backed Securities?
If you have decided to invest in MBS, you need to know the right strategy to minimize the risks. So, let’s see some tips that you should consider while investing in Mortgage Backed Securities:
- Understand the types of MBS because they are not the same and have different benefits
- Always choose an investment that matches your risk tolerance
- Pay attention to interest rates
- Always check the credit quality of the loans
- Choose MBS with stable prepayment characteristics
- Avoid investing all your money in one type of security
- Compare Yields with similar investments
Final Thought
In the world of investment, mortgage-backed securities are considered a powerful option that benefits both banks and investors. With steady income, portfolio diversification, and exposure to real estate returns, MBS is attracting attention from many investors. If you are one of them, start investing in mortgage-backed securities, and Reliance Financial will help make it a reality.
FAQ about Mortgage Backed Securities
Q. Do we need to spend a large amount of money on MBS?
This depends on how you invest in MBS, like if you make a direct investment in mortgage-backed securities, then you will need to make a large investment. But if you invest through Mutual Funds, ETFs or other methods, you will need to invest a minimum payment.
Q. Are Mortgage Backed Securities suitable for retired investors?
Yes, why not? MBS can be a good and most suitable option for retired investors as they can get a stable monthly income, moderate risk, and predictable returns.
Q. What are the risks associated with MBS?
With mortgage-backed securities, you will need to face some risks, such as:
- Prepayment risk
- Extension risk
- Interest Rate Risk
- Credit risk
Q. Is MBS good for beginners?
Yes, MBS can be good for beginners only if they choose the right type, and CMOs should be avoided by beginners.
Q. Is MBS a government-backed investment?
Only some Mortgage Backed Securities are backed by the Government, such as Agency MBS are issued by the government.
