Economics 434 Financial Markets Professor Burton University of Virginia Fall 2015 November 10, 2015

Mortgage Loans Let’s say you want to buy a $400,000 house… what happens? One option – you write a $400,000 check, and the house is yours (unlikely). Alternatively, you could approach a bank to take out a loan to buy the house.

This is a mortgage loan. Mortgage Loans Based on your credit history, income, etc. they provide terms for the loan. If you accept: You provide a down-payment (say, 20%). They provide the remaining funds to purchase the house. Those funds become a loan secured by the house.

Mortgage Loans Returning to our example – let’s say the bank offers you a 20% down, 6% annual interest rate conventional loan. You accept, and put 20% of $400,000 down = $80,000 down. The remaining $320,000 becomes a mortgage loan that you need to repay over the next 30 years.

Mortgage Loans How does this repayment work? One possibility, following the example of Treasuries: Semi-annual payments of 6% / 2 ¢ $320,000 = $9,600 every 6 months for next 360 months Both the $9,600 interest payment and $320,000 principal payment in month 360 Instead, most mortgage loans are self- amortized.

Mortgage Loans Month BOM Balance Int. Rate Interest Payment Principal Payment EOM Balance 0 (now) $320, %$1,600.00$ $319, %$1,598.41$ $319, % $1,596.81$ $319, $3, %$19.04 $1, $1, $1, %$9.55 $1, $0 In our example: Monthly Payment $1, …… ……………..…….………….. …………. …………….. …………..

Mortgage Loans Notice that the principal decreases every month, since the monthly payments exceed the interest. As a result, the interest due each month decreases as well. However, the total monthly payment remains constant. Therefore, initial payments are mainly interest and very little principal, while final payments are mainly principal and very little interest.

Mortgage Loans How do interest and principal payments change over time?

Mortgage Loans Total Monthly Payment broken down into Interest vs. Principal

Mortgage Loans Some stats on this mortgage loan: 360 payments of $1, each means $690, in total. This satisfied an initial debt of $320, Therefore: – Total Principal Payments = $320, – Total Interest Payments = $370, Not atypical for total interest paid and total principal paid to be about the same – they are exactly equal for an interest rate of ~5.25%, and close for similar rates.

Mortgage Loans Fast-forward 5 years… you have $300,000 left in principal on your mortgage loan. Also, real estate prices have increased – your house is now worth $500,000. Lastly, interest rates have dropped – to, say, 4%. Is there any way to take advantage of this situation? Yes… you can refinance!

Mortgage Loans Month BOM Balance Int. Rate Interest Payment Principal Payment EOM Balance 0 (now) $400, %$1,333.33$ $399, %$1,331.41$ $398, % $1,329.48$ $398, $3, %$12.67 $1, $1, $1, %$6.34 $1, $0 Let’s say you take out a new mortgage for $400,000: Monthly Payment $1, …… ……………..…….………….. …………. …………….. …………..

Mortgage Loans So… what’s changed? You’ve gotten $400,000 in cash now. Your monthly mortgage payment has dropped. Your mortgage has been extended by 5 years. Since you owed ~$300,000, you’ve essentially gotten $100,000 in cash today in exchange for paying ~$1,900 per month for 60 months starting 25 years from today. This is like getting a $100,000 loan at a 0.54% rate. (!!)

Mortgage Loans What does this whole process depend on? You must be able to re-pay your first mortgage – this is why removing the prepayment penalty is a benefit to consumers. If interest rates increase, consumers can keep their old rates, and without a prepayment penalty, as interest rates drop, consumers can lock in the new rate as well.

Mortgage Loans The new interest and principal payments over time:

Mortgage Loans New monthly payment’s interest vs. principal breakdown

The End

Topics for 2 nd Mid Term Present Value: Concept & Calculations Default Free Securities – Bills, Notes, and Bonds Auctions Definitions – Duration risk Defaultable Securities – Yield Curve – ABS – Asset Backed Securities The Swaps Market CDS Mortgages November 10, 2015

Format Similar to First Mid Term – First question – 8 identifications or definitions – Four additional questions/calculations/problems – Bring nothing to the exam – no calculators, books, extra paper, nothing….. – All answers written directly on the exam November 10, 2015