Mortgage Cash Flow Characteristics

  • Simply put, a mortgage is a debt instrument that is backed by real estate as collateral.
  • Fully Amortized Mortgage Loan: Borrower makes an equal monthly payment that includes an interest component and a principal repayment component.
    • In the early years of the repayment schedule, interest makes the largest share of the monthly payment, as principal repayment takes over as the largest share in the later years.

With a TI BA2+ calculator, the monthly payment can be obtained by entering the following:

  • PV = Mortgage Amount

  • I/Y = Monthly interest rate (i.e. the annual interest rate / 12)

  • N = Number of months in mortgage (i.e. 12 * number of years)

  • CPT PMT: Will generate monthly mortgage payment

  • When a private investor purchases a mortgage from a financial institution as an investment, the financial institution will take out a service fee from the mortgage's coupon rate.

Investor's Net Interest/Net Coupon = Gross Coupon - Service Fee

  • Commonly mortgages can be wholly or partially pre-paid at the borrower's discretion, without penalty.
    • NOTE: when evaluating asset backed securities it is critical to know whether or not the borrower can prepay without penalty. This will impact the security valuation approach; more to come.
  • Prepayment: Payment in excess of the required monthly minimum; commonly applied as a reduction of principal.
  • Curtailment: Borrower prepays only a portion of the debt principal.
    • Example: a borrower with an amortizing mortgage loan pays above the monthly minimum, but not so much that the payment covers the full remaining balance of the debt.
  • In the event the mortgage market rates drop below the borrower's existing rate, then the borrower has an incentive to refinance.
  • Refinancing: Taking out a new lower rate mortgage to repay the existing higher rate mortgage.
  • Prepayment Risk: Risk to the lender (investor) that the borrower will repay the mortgage principal sooner than expected and the lender will be forced to reinvest (or relend) the funds at a lower interest rate.

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