CFA Level I Exam · Fixed-Income Securitization

Residential Mortgage Loans and Mortgage Types for CFA Level I

Updated 7 October 2026 · Fact-checked

A residential mortgage loan is a loan secured by a home. Its key features are the rate type (fixed or adjustable), repayment type (fully amortizing, interest-only or balloon), loan-to-value ratio, prepayment penalties, and recourse. To solve questions, identify each feature, then ask who bears interest rate, prepayment or default risk.

Understand Residential Mortgage Loans and Mortgage Types

A mortgage loan is a loan secured by real estate. The borrower gets cash and promises to repay. The lender holds a lien on the property. If the borrower stops paying, the lender can foreclose, which means selling the property to recover what is owed. A residential mortgage is backed by a home. A commercial mortgage is backed by income-producing property such as offices or malls.

The contract terms decide who carries which risk. The rate type is one term. A fixed-rate mortgage keeps the same rate for the whole life, so the lender carries the interest rate risk: if market rates rise, the lender is stuck with a below-market rate. An adjustable-rate mortgage (ARM) resets the rate from time to time as a reference rate plus a fixed margin. This shifts interest rate risk to the borrower, because the payment can rise. ARMs often have caps (limits on how much the rate can rise) and floors (limits on how low it can fall).

The repayment type is another term. A fully amortizing loan has level payments that cover interest and some principal, so the balance reaches zero at maturity. An interest-only loan has payments of interest only for a set period. The principal is then repaid at the end or starts amortizing later. A balloon loan amortizes only partly, so a large final payment is due at maturity. These loans carry more refinancing risk for the borrower, because the balloon has to be paid or refinanced.

The loan-to-value (LTV) ratio measures how much of the property value is financed by the loan. A higher LTV means less borrower equity and more default risk for the lender. Lenders often use the lower of the purchase price and the appraised value as the value. Two other terms matter. A prepayment penalty is a fee charged if the borrower repays early. It protects the lender from losing expected interest. Recourse decides what the lender can take after default. With a recourse loan, the lender can claim the property and then pursue the borrower's other assets for any shortfall. With a non-recourse loan, the lender can claim only the property. This gives the borrower a default option, because they can hand over the property if it is worth less than the loan.

Key formulas to remember

Loan-to-value ratio: LTV = Loan amount ÷ Property value; Property value is usually the lower of purchase price and appraised value. Higher LTV means higher credit risk for the lender.
Level payment on a fully amortizing loan: Payment = PV × r ÷ [1 − (1 + r)^(−n)]; r is the periodic rate (annual rate ÷ 12 for monthly payments). n is the number of payments. On the calculator, set N, I/Y, PV, then CPT PMT.
Interest-only payment: Payment = Loan balance × periodic rate; The balance does not fall during the interest-only period, so the full principal is still owed afterwards or at maturity.
Adjustable-rate mortgage rate: New rate = Reference rate + Margin (subject to caps and floors); The margin is fixed for the life of the loan. The reference rate changes at each reset date. An ARM shifts interest rate risk to the borrower, because the payment can rise.
Recourse vs non-recourse rule: Recourse: claim on property + borrower's other assets. Non-recourse: claim on property only.; Non-recourse lending gives the borrower a put-like default option and so increases lender credit risk.

How to solve Residential Mortgage Loans and Mortgage Types questions

Use this method for any question on mortgage loan features. Most items test one feature and one risk.

1Read the stem and list the features given: rate type, repayment type, LTV, penalty, recourse.
2Name the risk each feature creates. Fixed rate means lender interest rate risk. ARM shifts interest rate risk to the borrower (the payment can rise). Balloon or interest-only means refinancing risk. Non-recourse means higher lender credit risk.
3If a number is asked for, pick the right formula: LTV, interest-only payment, or level payment.
4Check the periodic rate. Divide the annual rate by 12 for monthly payments and use months for N.
5For LTV, confirm which value the question tells you to use: price, appraisal, or the lower of the two.
6Compute, then test the three options. Numerical options go from smallest to largest, so check that your answer fits the order and size.
7Eliminate options that reverse who bears the risk, or that treat a non-amortizing loan as one that repays principal.

Quickest way: Feature-to-risk shortcut

When to use it: Use this for conceptual questions where you have about 90 seconds and no calculation is needed.

Find the keyword: fixed, adjustable, interest-only, balloon, prepayment penalty, recourse, non-recourse, LTV.
Match it to one line: fixed = lender bears rate risk; ARM = borrower bears rate risk (payment can rise); balloon or interest-only = refinancing risk; penalty = lender protected against prepayment; non-recourse = lender can take only the property; high LTV = more default risk.
Cross out any option that gives the opposite of that line.
For LTV, just divide the loan by the value given and compare with the options.

Common mistakes in Residential Mortgage Loans and Mortgage Types

Saying the borrower carries interest rate risk on a fixed-rate mortgage.
Students think about the borrower's payment, which is stable, and forget that the lender's funding cost can rise.
Fix: Ask who is hurt when market rates move. On a fixed-rate loan, the lender is stuck with a below-market rate when rates rise. On an ARM, the borrower's payment changes.
Thinking an interest-only loan reduces the principal.
Students assume every mortgage payment includes some repayment of principal.
Fix: During the interest-only period, the payment equals balance × periodic rate and the balance stays the same. Principal is repaid later or as a balloon.
Mixing up recourse and non-recourse.
The words sound alike and students forget who is protected.
Fix: Non-recourse means the lender's recourse stops at the property. The borrower is protected from further claims. Recourse allows claims on the borrower's other assets.
Using the annual rate with monthly payments.
Students rush to enter 5 as the rate and 30 as N in the calculator.
Fix: For monthly payments, use the annual rate ÷ 12 and N = years × 12. On the BA II Plus, set P/Y = 12 and enter N = 360, I/Y = 5.
Treating a higher LTV as lower risk.
Students read 'value' as the borrower's stake rather than the loan's share of value.
Fix: LTV is loan ÷ value. A higher LTV means a smaller equity cushion, so more default risk and a higher loss if the home is sold for less.
Saying a prepayment penalty protects the borrower.
Penalties are seen as a cost, so students think they punish the lender.
Fix: The penalty is a fee paid by the borrower to the lender when repaying early. It reduces the lender's prepayment risk and makes the loan's cash flows more predictable.

Worked examples

Example 1

A buyer purchases a home for $400,000. The appraised value is $380,000. The lender uses the lower of price and appraised value and lends $304,000. The loan-to-value ratio is closest to: A. 76% B. 80% C. 85%

Show the solution

Pick the value the lender uses: the lower of $400,000 and $380,000 is $380,000.
Apply the formula: LTV = 304,000 ÷ 380,000.
Compute: 304,000 ÷ 380,000 = 0.80, which is 80%.
Check the traps: 76% comes from dividing by the price of $400,000 (304,000 ÷ 400,000). 85% is not supported by any value in the question.

Answer: B. 80%

Example 2

A borrower takes a $500,000 interest-only mortgage at an annual rate of 5%, paid monthly, with the full principal due at maturity. The monthly payment is closest to: A. $2,083 B. $2,500 C. $2,684

Show the solution

Find the periodic rate: 5% ÷ 12 = 0.4167% per month.
Interest-only payment = 500,000 × 0.05 ÷ 12 = $2,083.33.
Check the traps: $2,684 is approximately the payment on a 30-year fully amortizing loan at 5% (BA II Plus: N = 360, I/Y = 5 with P/Y = 12, PV = 500,000, CPT PMT gives about −2,684). $2,500 uses a 6% rate by mistake (500,000 × 0.06 ÷ 12).
Because no principal is repaid, the balance stays at $500,000 and is owed as a balloon at maturity.

Answer: A. $2,083

Exam tips

Expect one-line conceptual items that ask who bears a risk. Learn the feature-to-risk pairs by heart.
Questions on recourse often test the borrower's default option. Non-recourse makes default more attractive when the home is worth less than the loan.
For LTV, read which value the stem tells you to use before dividing. Lower-of-two is a common trap.
With numerical options listed smallest to largest, an interest-only payment will usually be the smallest option. The amortizing payment is higher.
If you must guess, remember that all questions score equally and there is no penalty for a wrong answer. Narrow to two options and move on.

Practice questions from Fixed-Income Securitization

Residential Mortgage Loans and Mortgage Types in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

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Residential Mortgage Loans and Mortgage Types: frequently asked questions

What is the difference between recourse and non-recourse mortgage loans?

With a recourse loan, the lender can take the property and also pursue the borrower's other assets if the sale does not cover the debt. With a non-recourse loan, the lender can claim only the property. So non-recourse lending carries more credit risk for the lender.

What is the difference between fixed-rate and adjustable-rate mortgages?

A fixed-rate mortgage keeps the same rate for the life of the loan, so the lender bears interest rate risk. An adjustable-rate mortgage resets the rate periodically to a reference rate plus a margin, so interest rate risk shifts to the borrower, whose payment can rise. Caps and floors limit how far the rate can move.

What is the loan-to-value ratio in a mortgage?

The loan-to-value ratio is the loan amount divided by the property value. Lenders often use the lower of purchase price and appraised value. A higher ratio means less borrower equity and higher default risk.

What is a prepayment penalty?

A prepayment penalty is a fee a borrower pays if the loan is repaid earlier than allowed. It compensates the lender for lost interest. It makes early repayment less attractive, which reduces prepayment risk.