Mortgage-backed securities are bonds that are secured by home and real estate loans

• Mortgage-backed securities (MBS) are bonds that use groups of mortgage loans as collateral.
• An MBS can be issued by a government agency, government-sponsored entity, or a private institution.
• Unlike most other bonds, mortgage-backed securities make monthly payments of interest and principal.

Mortgage-backed securities are bonds that use a pool of real estate loans, including residential mortgages, as collateral. Once created by a bank or investment company, the pool is sold to a federal agency, government-backed institution, or securities firm where it is then used as collateral for a mortgage-backed security.

Investing in an MBS can be a complicated process for investors. It's important to find trustworthy issuers and to understand the rules that determine your investment return.

How mortgage-backed securities (MBS) work

Mortgage-backed securities are created when a bank or other financial entity that owns mortgage loans pools several mortgages together based on their similar characteristics, such as interest rate and repayment period. Fixed-rate mortgages, adjustable-rate mortgages, and residential mortgages may make an MBS.

Once a pool is created, it is then sold to an MBS issuer to securitize the pool and create an MBS. Issuers include government agencies (like Ginnie Mae), government-sponsored institutions (like Fannie Mae and Freddie Mac), or private securities firms (known as private-label MBSs). Government agencies offer the strongest guarantee to make payments on their MBSs than private or government-sponsored entities.

Quick tip: Buying an MBS from a government agency is the safest option, as it will be backed by the "full faith and credit" of the federal government. Government-sponsored entities also have some Treasury backing, but not quite as much security.

Afterward, you can then buy an MBS through a broker.

"When you're investing in mortgage-backed securities, you're lending money to home buyers," says Lyle Solomon, a bankruptcy attorney with Oak View Law Group in California. "So, in return, you have the right to the money (or the mortgage amount for a home buyer) you are lending."

Essentially, MBS bondholders are rewarded with monthly payments of both interest and principal. In the early days of MBS investment, the monthly payments consist mostly of interest. As time goes on, they include more principal in the amount.

An MBS makes payments to investors each month because the homeowners of the collateralized mortgages are making their mortgage payments monthly. Much like mortgage payments, MBS payment amounts vary from month to month.

Types of mortgage-backed securities

The two main types of mortgage-backed securities are pass-throughs and collateralized mortgage obligations (CMOs).

Pass-throughs are a standard MBS where the issuer collects mortgage payments in a trust and distributes — or passes through — the money to investors. Pass-through MBSs typically have maturities of five, 15, or 30 years. But on average, they last much less than the stated maturity since the payouts depend on how the underlying mortgages are being paid down.

Collateralized mortgage obligations are more complicated because they comprise several pools of securities, called tranches or slices, rather than one pool of similarly characterized mortgages. Each pool in a CMO has its own characteristics including interest and principal distribution rules. These payments are made to the different classes of securities according to a certain priority of payments.

Quick tip: You'll likely need financial expertise to help you with an MBS investment, but you'll definitely want professional guidance with a collateralized mortgage obligation MBS.

Pros and cons of mortgage-backed securities

Mortgage-backed securities can offer some great diversification to an investment portfolio. They're an investment that also provides monthly payouts, which can appeal to investors who want some extra income each month. But these payments vary in amounts, which doesn't offer the consistency that some investors may want from their income streams.

MBSs are subject to the risks that stem from the collateralized mortgages. Homeowners may refinance their loans, which could result in prepayment, or paying out principal to investors earlier than planned. As an investment, an MBS also exposes investors to market and liquidity risk.

MBSs vs bonds

MBSs largely differ from other bonds in their payment structure. Bonds typically make payments of the principal semiannually or at maturity, while MBSs make payments of both interest and principal monthly.

Government bonds, such as Treasury and ​​Series EE savings bonds, tend to have lower investment thresholds. For example, a Treasury bond requires a $100 minimum to purchase and an EE bond requires as low as $25 to buy. MBS are known for higher minimum investment requirements, typically around $10,000.

The financial takeaway

Mortgage-backed securities are complex investments that require plenty of research and due diligence. You first want to make sure you're buying from a legitimate issuer. You may also want to enlist the help of an investment professional so you can find an MBS that can provide the returns you want.

You will also need a sizable amount to buy an MBS, which makes these bonds tricky for very beginner investors.