LECTURE 3: MORTGAGE MARKETS I A Basic Mortgage Scenario Overview • You want to purchase a residential property. • You do not have sufficient funds to pay for it. • A basic mortgage scenario • You borrow money or take a loan from a financial • The mortgage instrument institution(FI). • Mortgage mathematics • The FI will demand a collateral for granting you the loan. • Fixed rate mortgages • Your property will be the collateral. • Adjustable rate mortgages • Such a loan (where your property is the collateral) is called a mortgage. • CPF financing • You buy the property and service the mortgage. The Mortgage Instrument The Mortgage Instrument - Elements • A mortgage is created in a transaction whereby one • Loan Amount or Principal party pledges real property to another party as security • Interest Rate or Coupon for an obligation owed to that party. • Loan Maturity Period or Duration • A mortgage involves a transfer or conveyance of an • Method and Timing of Debt Service/Amortisation interest in real estate with a provision for redemption. • Loan-to-value Ratio • The FI is the creditor/lender/mortgagee. It has a legal or equitable interest on your property. • Debt Coverage Ratio • You are the debtor/borrower/mortgagor. • Other Special Provisions - Fees • Redemption is the repayment to discharge the loan - Early Repayment outstanding. - Others Mortgage Mathematics Fixed Rate Mortgages (FRMs) • Suppose you take out a mortgage for $60,000 for 30 • Two types: years at a fixed interest rate of 12% p.a. What is the – Constant Amortisation Mortgage (CAM) where the principal is annual mortgage debt service (assuming annual reduced by a constant amount each period compounding)? – Fully Amortising, Constant Payment Mortgage (CPM) where a constant amount is repaid each period but the principal reduction Principal = PVA = $60,000 is not constant Interest rate = i = 0.12 • FRMs which are CPMs have Number of payments = n = 30 – constant monthly payments based on an original loan amount at Annual debt service = $60,000 (MC12%,30yrs) a fixed interest rate for a given term – payment comprises interest and some (though not a constant) = $60,000 (0.124143657) repayment of principal = $7,448.62 FRMs - An Example FRMs - Loan Amortisation Pattern $60,000 loan at 12% for 30 years, monthly rest./compounding Monthly debt service based on a CPM uses PVA/MC Period Beginning Debt Interest ($) Principal Ending formula Balance ($) Service ($) Amortisation ($) Balance ($) ANN1%,360 mths = PVA (MC1%,360mths) 1 60,000.00 617.17 600.00 17.17 59,982.83 ⎡ ⎤ ⎢ i ⎥ 2 59,982.83 617.17 599.83 17.34 59,965.49 = $60,000 ⎢⎣1− (1+ i) ⎥⎦ ⎢ −n ⎥ 3 59,965.49 617.17 599.65 17.51 59,947.98 . . . . . . . . . . . . = $60,000 (0.01028613) . . . . . . = $617.17 360 611.06 617.17 6.11 611.06 0 FRMs - Graph of Amortisation Pattern FRMs - Mortgage Balance • Mortgages may be repaid before they mature for various Payment Debt reasons. Service • Suppose you want to repay the loan after 10 years. What is the outstanding mortgage balance at the end of year Principal 10? • Compute the mortgage balance using the PVA formula Interest where the annuity is the monthly payment and n is the term remaining until loan maturity. Mortgage Balance = ANN (PVAF1%, 240mths) Time = $617.17 (90.81941635) = $56,051.02 FRMs - Loan Origination/Closing Fees FRMs - Effective Borrowing Cost • Generally, closing costs include statutory costs, third- Suppose the lender charges 3%(points) upfront on the party charges and additional finance costs/charges. loan. • Finance fees cover the “fixed cost” elements of mortgages and are additional income received by the • 3% of $60,000 = $1,800 lender. • Borrower receives only $58,200 rather than contractual • Fees are charged upfront to the borrower and result in a sum of $60,000. (Hence, the term “discount”) discount on the loan. • Debt service is still based on principal of $60,000. • Significance: • Because the borrower receives only 97% of principal – increase the cost of borrowing to the borrower sum but makes payment based on 100% of principal – increase the yield/return to the lender amount, the actual borrowing cost to the lender is more than 12%. FRMs - Effective Borrowing Cost FRMs - Rationale for Loan Fees To determine the effective cost of the loan to the • Increase the yield or return on mortgage loans borrower or the effective interest return to the lender for lenders. denoted r, equate the PV of $58,200 with the PV of 360 monthly payments of $617.17 at the rate r. • Marketing tool. • Protect lenders against “sticky” mortgage rates: $617.17(PVAr%,360mths) = $58,200 upward movement in market interest rates may PVAr%,360mths = $58,200/$617.17 = 94.30140804 occur but mortgage rates may still be r = 1.03% per month (12.41%) > 1% per month (12% unchanged. p.a.) • In U.S., lenders must disclose the APR (Annual Why is the effective interest rate higher? Percentage Rate) being charged on the loan. FRMs - Loan Fees and Early Repayment Loan Fees and Early Repayment • Mortgages are sometimes repaid before the full • Say you repay the loan at the end of 5 years. term/maturity of the loan. • Mortgage Balance still outstanding at the end of • Early loan repayment may be because of 5 years = PV of 300 monthly payments of – divestment/sale of property $617.17 at 12% p.a. = $58,597.93. – death • Solve for r, the effective interest rate per month: – divorce $58,200 = $617.17(PVAFr%,60mths) + $58,597.93 – disability (PVFr%,60mths) – dislocation r = 1.069% p.m > 1.03% p.m. Loan Fees and Early Repayment Prepayment Penalty • When loan fees are charged upfront and the • Borrowers mistakenly assume a loan can be prepaid in loan is repaid before maturity, the effective part or in full anytime before maturity. interest cost of the loan is even higher. • Most FIs impose a prepayment penalty, notice of partial prepayment &/or notice of redemption. • Why? What if you repaid the very next day? • Rationale: • What if there were no upfront loan fees? Would - allows the lender to recover loan origination costs you care if you had to prepay? - compensates lender for risk that he may not be able to • Moral Hazard Issue: The lender doesn’t know reinvest the funds from prepayment to earn similar when you will prepay but you have some idea. yields if interest rates have fallen since origination - compensates lender for promotional /preferential rates Prepayment Penalty FRMs - Cash Flow Time Line • Say the prepayment penalty is 3% on the Payment at outstanding mortgage balance or 3% of EOY 5 = DS Debt Service $58,597.93 (= $1757.94). + MB + PP of $617.17 p.m. • If the loan is prepaid at the end of 5 years, the Time effective interest cost r is solved as follows: $58,200 = $617.17(PVAFr%,60mths) + $60,355.87 (PVFr%,60mths) $58,200 at time EOY 0 r = 1.104% p.m > 1.069% p.m.