Mortgage Cash Flow Characteristics

This lesson is part 2 of 25 in the course Fixed Income Part 2

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:

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.