Given the recent news around the US Housing Market and the Freddie Mac, I thought that I should start tackling the Subprime Mortgage crisis, the Debt Ceiling Crisis, the America-in-General crisis, and all the fun stuff that goes with it.
But before I can get to that, I think I may have to back-track a little to discuss mortgages, and mortgage-backed securities. Like I’ve said before, we all know that having a mortgage is related to owning a house. In America, it’s also related to living the dream. But for many people my age, a mortgage is something to think about:
- When you’re getting married; and
- Once you’ve found a real job (that pays real money).
And my age group is just about there. At least, we’re getting married. The real job is more of a hit-and-miss situation.
Mortgage: the official name for a hire-purchase arrangement attached to buying a house. The purchase price of the house is borrowed upfront, and then repaid over a specified period of time in regular instalments. Each instalment comprises a portion of principal (the original purchase price/capital amount) and a portion of interest (the cost of borrowing the capital).
It generally works as follows:
- You find the house you want.
- You find out how much it costs
- You then approach a bank in search of finance.
- You fill out a large number of forms which look a lot like a stylised version of your facebook profile, except with more emphasis on your payslip, your monthly debit orders, and your expensive and frequent taste in restaurants. Unlike facebook, there is also a frantic search for supporting documentation. Photoshopping – unfortunately, not encouraged.
- You wait.
- The bank then comes back to you with a mortgage proposal that is significantly lower than the cost of the house that you’d like to buy.
- You sign anyway, and find another house in your price range. There’s no ways that you’re going through that again.
Once you’ve found the house you can actually afford, the bank pays the purchase price. You then repay the bank in monthly instalments for however long a mortgage period we’re talking about (the mortgage period is known as the term). The important thing to note is that your instalments include two things:
- Principal – which is the capital amount you borrowed upfront; and
- Interest – which is the cost of borrowing the money from the bank.
As the interest is being calculated on the principal outstanding, the interest cost is highest at the beginning of the mortgage period, and gradually reduces as you pay back more principal. But this is all factored into the monthly instalment. So your first instalment will consist mostly of interest, with only a little principal being repaid. And over time, this ratio will shift in the other direction, as illustrated:
|Mortgage Repayments Over Time|
The above implies that you cannot get into a situation where your interest owing on the principal outstanding is greater than your mortgage instalment. If that were the case, the unpaid interest portion would also accrue interest, and you would enter into a “death warrant” situation, where you would never be able to pay off the debt (on the contrary, you would just go deeper into debt as time goes by!). That situation is a form of financial slavery. Many countries have made it illegal – in South Africa, we have the National Credit Act which prevents it from happening.
The other fact to point out is that a mortgage loan is collateralised by the house itself: which means that the bank will either get your mortgage repayments, or the house. When a home-loaner misses a mortgage repayment, the bank has the right to foreclose on the mortgage loan – which basically means that it takes ownership of the house and sells it to recoup (claim back) its loan.
So that’s the basic form of a mortgage. To recap:
- The home-owner has a mortgage liability where he/she is obliged to pay monthly instalments to the bank;
- The bank has a mortgage asset, where it is entitled to receive monthly instalments from the home-owner.
At this point, I’d like to bring in a few technicalities that will become more relevant when I post about the Subprime Crisis. Firstly, there are often variations in the type of interest rate specified in a mortgage contract:
- Fixed Rate Mortgages: are mortgages where the rate of interest is fixed in the contract (ie. the monthly instalments will be explicitly quantified in the loan contract). These are the common form of mortgages in the United States.
- Variable Rate Mortgages: are mortgages where the rate of interest is defined in the contract in relation to a published rate of interest (for example, in South Africa, we have the prime rate of interest – so the contract could specify “interest at Prime plus 1 per cent”). The mortgage repayments will therefore fluctuate with movements in prime. These are also known as “Floating Rate Mortgages”.
Now this is interesting to me because I think it demonstrates the relative empowerment of a population. Fixed Rate mortgages force the Bank to carry the interest rate risk; Variable Rate mortgages force the home-owner to carry the interest rate risk.
Interest Rate Risk: the risk that you will have to pay more when interest rates go up (in the case of the home-owner), or the risk that you will receive less when interest rates go down (in the case of the bank).
Clearly, where Fixed Rate Mortgages are in place, the bank will lose out if interest rates go up – as they could have earned more interest if they had a Variable Rate Mortgage.
But the bank will still benefit if the rates go down, right? Because the home-owner has committed to a fixed rate mortgage with the higher rate of interest?
No. If you’ve ever heard the phrase “refinance the mortgage” – this is where it comes into play. When interest rates go down, the home-loaner simply refinances. While I’m not sure of the exact way that it happens in the US banks, it makes sense to me because, if I were a home-owner, I would:
- Approach a new bank and take out a mortgage on my house at the low interest rate; and then
- Use the mortgage loan to pay off the original mortgage.
- Now I have a fixed rate mortgage at the low rate.
This leaves the banks fully exposed to the downside of interest rate risk, with none of the upside. Because no home owner is going to refinance when interest rates go up!
Two final terms that I’d like to introduce here are a “prepayment” and a “curtailment”.
A prepayment is a repayment of principal over and above the mortgage instalment. It effectively means that you will pay less interest over the mortgage term, thereby either reducing your monthly instalments, or shortening the mortgage term (if you continue to pay the original instalment amounts). Interestingly, prepayments are not encouraged by the bank – and there are often prepayment penalties imposed by the mortgage loan contract.
A prepayment usually refers to the settlement of the full outstanding capital amount, where a curtailment refers to a partial settlement.
In the next mortgage-related post, I will talk about Mortgage-Backed Securities. And after that, I can get to the really interesting part: the Subprime Crisis.
Gareth Crosland February 2, 2012 at 09:50
Your 'Mortgage Repayments Over Time' graph is most impressive! Colours and all….Reply
Caroline Banks February 2, 2012 at 10:42
This is now my favourite reading while eating breakfast 🙂Reply