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.
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.
This is a mortgage loan.
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
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 selfamortized.
Mortgage Loans
In our example:
Month
BOM
Balance
Int.
Rate
Interest
Payment
Monthly
Payment
Principal
Payment
0 (now)
EOM
Balance
$320,000.00
1
$320,000.00 0.5% $1,600.00 $1,918.56
$318.56
$319,681.44
2
$319,681.44 0.5% $1,598.41 $1,918.56
$320.15
$319,361.28
3
$319,361.28 0.5% $1,596.81 $1,918.56
$321.76
$319,039.53
……
…………….. ……. ………….. ………….. ………….
……………..
359
$3,808.54
0.5%
$19.04
$1,918.56 $1,899.52
$1,909.02
360
$1,909.02
0.5%
$9.55
$1,918.56 $1,909.02
$0
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?
$2,000.00
$1,500.00
Interest
$1,000.00
Principal
$500.00
$0.00
0
30
60
90
120
150
180
210
240
270
300
330
360
Mortgage Loans
Total Monthly Payment broken down into Interest vs.
Principal
$2,000
$1,500
Principal
$1,000
Interest
$500
$0
0
30
60
90
120
150
180
210
240
270
300
330
360
Mortgage Loans
Some stats on this mortgage loan:
• 360 payments of $1,918.56 each means $690,682.20 in
total.
• This satisfied an initial debt of $320,000.00.
• Therefore:
– Total Principal Payments = $320,000.00
– Total Interest Payments = $370,682.20
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
Let’s say you take out a new mortgage for $400,000:
Month
BOM
Balance
Int.
Rate
Interest
Payment
Monthly
Payment
Principal
Payment
0 (now)
EOM
Balance
$400,000.00
1
$400,000.00 0.33% $1,333.33 $1,909.66
$576.33
$399,423.67
2
$399,423.67 0.33% $1,331.41 $1,909.66
$578.25
$398,845.42
3
$398,845.42 0.33% $1,329.48 $1,909.66
$580.18
$398,265.25
……. ………….. ………….. …………. ……………..
……
……………..
359
$3,800.31
0.33%
$12.67
$1,909.66 $1,896.99
$1,903.32
360
$1,903.32
0.33%
$6.34
$1,909.66 $1,903.32
$0
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
Mortgage Loans
The new interest and principal payments over time:
$2,000.00
$1,500.00
Interest
$1,000.00
Principal
$500.00
$0.00
0
30
60
90
120
150
180
210
240
270
300
330
360
Mortgage Loans
New monthly payment’s interest vs. principal breakdown
$2,000
$1,500
Principal
$1,000
Interest
$500
$0
0
30
60
90
120
150
180
210
240
270
300
330
360
The End
Topics for 2nd 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
November 10, 2015