Tuesday, November 22, 2011

Mortgage Mechanics

The value of mortgage paper is a function of how a product is structured around the cash flows. I want to take the time today to explain what a mortgage is, theoretically. In the future, I will look to explain how the mortgage transfers into structured bond-type products in the capital markets.

Examples are great ways to explain a concept. A $500,000 listed home purchased with 10% down results in a $450,000 loan. We will assume that the purchaser qualifies for terms of a “fixed” 4.5% APR loan, with a duration of 30 years. An amortization calculator will confirm that the annual payment for such a loan will be around $27,600 per year, or the equivalent of $2,300 per month. For the sake of explanation, let’s ignore taxes, fees, and any other overhead costs.

The result of paying $27,600/yr over 30 years comes out to an actual liability outlay of $828,000. This assumes, further, that there will be no refinancing or any modification to the terms of the loan. The topic quickly becomes controversial and a bit of a catch-22. The accounting number says that we bought a $500,000 value home, while the “economic” cost is, in this case, $828,000, a significantly higher sum. The market listed price really doesn’t reconcile with the real cost.

You better trust whomever it is you work with to explain concepts like this.

Back to the example. The $328,000 difference represents the total interest cost—compensation for the lender who is assuming the risk. Much more can be said on the topic of ‘risk'. Important to recognize is how increasing the time horizon or the interest rate can have a dramatic magnifying effect. In our example, if we increased the APR to 5%, a mere 50 basis point increase, the total interest outlay raises from $328k all the way to $379k, a difference of $51,000! Put another way, one-half of one-percent on a $450,000 loan is the equivalent of a 11% total increase in price ($51k / $450k) or a 6% increase in total cost ($51k / $828k) over thirty years!

More to come…