What Is it?
A mortgage-backed security (MBS), also known as a "mortgage pass-through" or a "pass-through certificate", is an investment instrument that represents ownership of an undivided interest in a group of mortgages. Principal and interest from the individual mortgages are used to pay principal and interest on the MBS.

When you invest in a mortgage-backed security, you are lending money to a homebuyer or a business. MBSs are a way for small regional banks to give mortgages to their customers without having to worry if they have the assets to cover the loan. Instead, the bank acts as an intermediary between the homebuyer and the investment markets.

Who pools these mortgages together? The majority of MBSs are issued and backed by government-sponsored corporations such as the Government National Mortgage Association (Ginnie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). Each entity offers a slightly different variation in the securities it issues. Ginnie Mae MBSs are typically the most popular and widely held because they are backed by the U.S. government, whereas Fannie Mae is government sponsored but also trades as a public company.

Objectives and Risks
Mortgage-backed securities are an undiscovered gem. While these securities are primarily used to provide safe income, there is also the opportunity to get some capital appreciation as interest rates fall. Another advantage to MBSs is that they are very suitable for most tax-deferred savings accounts.

Generally, MBSs are traded actively, much like bonds are, so there is very little liquidity risk. Furthermore, they are considered an extremely safe investment, often said to have the same credit worthiness as treasuries but with a return that is 1-2% greater. Monthly income from MBSs can vary as interest rates change because mortgages can be prepaid, and when interest rates are falling, prepayments tend to rise. Prepayments only shorten the life of the MBS and are passed directly to the investors.

How To Buy or Sell It
Mortgage-backed securities can be purchased at almost any full-service broker. More and more discount brokers are offering MBSs as well. These securities don't come cheap - most are sold in chunks of $25,000. But there are some variations of MBS (called collateralized mortgage obligations, or CMOs) that can sell for under $5,000.



Strengths
  • Very low-risk investment that offers a return that\'s 1-2% higher than comparable low-risk securities.
  • Most MBSs are either fully backed or sponsored by the U.S. government.

  • Weaknesses
  • Minimum investment can be fairly high, upwards of $25,000.
  • Outside of a retirement account, there are virtually no tax advantages to owning an MBS. The income from an MBS is taxed as regular income.

  • Three Main Uses
  • Provide Income
  • Capital Appreciation
  • Tax-Deferred Savings

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