# What Are Residential Mortgage-Backed Securities (RMBS)? Benefits and Risks

## What Is a Residential Mortgage-Backed Security (RMBS)?

Residential mortgage-backed securities (RMBS) are debt instruments backed by pools of residential loans, including mortgages and [home-equity loans](https://www.investopedia.com/terms/h/homeequityloan.asp). These securities offer investors the potential for high returns by distributing payments from numerous individual mortgages. However, they carry risks like prepayment and credit risk, impacting investor profitability.

Born out of a demand for home ownership, RMBS have played significant roles in financial markets, including the 2008 financial crisis, when poorly-constructed RMBS contributed to economic instability.

### Key Takeaways

*   Residential mortgage-backed securities (RMBS) are debt-based assets backed by interests from residential loans such as mortgages and home-equity loans.  
*   RMBSs are created by pooling multiple mortgages together, allowing investors to receive payments based on the collective interest paid by borrowers.  
*   RMBSs can offer higher interest rates than government-backed bonds but come with risks such as prepayment and credit risk.  
*   The poor construction of RMBSs played a significant role in the 2008 financial crisis, highlighting the importance of quality underwriting.  
*   Understanding the different types of mortgages included in an RMBS is crucial as they can vary in rate types and credit quality.

## Understanding the Mechanics of Residential Mortgage-Backed Securities

A residential [mortgage-backed security](https://www.investopedia.com/terms/m/mbs.asp) is constructed by a government agency such as the [Federal National Mortgage Association](https://www.investopedia.com/articles/investing/091814/fannie-mae-what-it-does-and-how-it-operates.asp) (Fannie Mae) and the [Federal Home Loan Mortgage Corporation](https://www.investopedia.com/terms/f/freddiemac.asp) (Freddie Mac) or a non-agency investment-banking firm. These entities sell or control a large number of residential loans. They package them together into a single pool of loans and essentially sell bonds backed by this pool of loans.

Loan payments go to the investors in the pool, and the interest rates they earn may be higher than U.S. government-backed bonds. The issuing institutions keep a fee for the management of the pool, and the risks of default on these mortgages are shared by both the issuing entities and the investors.

## Weighing the Pros and Cons of Residential Mortgage-Backed Securities

An RMBS has the advantage of providing less risk and greater profitability to investors. It allows the issuing entities to raise more cash for reserves, against which they can make more loans. RMBS investors, like life insurance companies, efficiently invest billions in higher-interest investments with acceptable risks compared to government bonds.

An RMBS may include different types of mortgages. They may contain mortgages with fixed rates, floating rates, adjustable rates, and mortgages of varying credit quality. RMBS face risks like financial system stress impacting all investments in the pool, as seen in the [2008 financial crisis](https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp).

## Exploring Investment Strategies with Residential Mortgage-Backed Securities

Investing in a residential mortgage-backed security can expose the investor to [prepayment](https://www.investopedia.com/terms/p/prepayment.asp) risk and [credit risk](https://www.investopedia.com/terms/c/creditrisk.asp). Prepayment is when the mortgage holder pays back the mortgage before its [maturity date](https://www.investopedia.com/terms/m/maturitydate.asp), reducing the interest the investor receives. Credit risk for RMBS investors arises when the borrower stops making payments on his mortgage.

Financial institutions, such as insurance companies, use RMBS to generate long-term cash flow. Buyers of residential mortgage-backed securities often help determine how they are constructed, so they can be uniquely tailored to offset a liability or to fit investor preferences for risk, return, and timing of cash flows.

## What Is the Difference Between RMBS and CMBS?

Residential Mortgage-backed securities (RMBS) are backed by residential mortgages, generally for single-family homes. Commercial mortgage-backed securities (CMBS) are backed by commercial loans.

## What Types of Mortgages Are Included in an RMBS?

RMBS are pools of residential mortgage loans that may include different types of fixed or floating-rate loans. The security can be issued by Fannie Mae or Freddie Mac and include [conforming loans](https://www.investopedia.com/terms/c/conformingloan.asp). Non-agency RMBS issued by private financial institutions consists of mortgages that are considered [non-conforming](https://www.investopedia.com/terms/n/non_conforming.asp).

## Are RMBS Considered Collateral Backed Investments?

RMBS consists of pooled small mortgage home loans backed by the houses as collateral, so the default risk associated with them is commonly low.

  

## The Bottom Line

Residential mortgage-backed securities (RMBS) provide a form of investment that combines residential mortgages and home-equity loans into pools. Constructed by entities like Fannie Mae, Freddie Mac, or private firms, RMBS distribute payments from the underlying loans to investors, offering potentially higher interest rates than government bonds. However, risks, such as prepayment and credit risk, can impact returns.

Understanding the structure and risks of RMBS helps investors evaluate their potential for profit while managing exposure to default risks.