As a twist on the typical prepay mortgage v. invest threads, I have been thinking about the following scenario.
From the bank’s perspective, a mortgage is similar to a bond. I understand that it is not quite the same as a traditional bond because each payment is both interest and principal, and the interest is front-loaded. Thus, the yields are calculated differently. But for both, if interest rates rise over the next few years, the price for which the bank can sell existing, lower rate mortgages should decline. If that is correct, at some point the bank should be willing to allow a borrower to repurchase the mortgage at a cost below the payoff amount.
Here is an example:
Assume a 15-year mortgage for $100,000 financed at 2.5%. At the end of Year 3, assume the market interest rate for a 15-year mortgage is 5%. At this point the remaining principal of the mortgage is $82,879, the remaining interest is $13,138, and the duration is 12 years. The monthly payment is $667. A buyer who purchases this mortgage in Year 3 for $72,150 will achieve a mortgage yield to maturity of 5%. (mortgage yield calculation, not bond yield calculation) In other words, $72,150 is the market price of the mortgage in Year 3.
In Year 3, if the borrower approached the bank with an offer to buy back the mortgage for $75,000 (or some other amount over the market price sufficient to cover transactional costs), wouldn’t it make sense for the bank to accept the offer notwithstanding the fact that the price is less than the remaining principal?
If so, has anyone tried to do this or know of a mechanism whereby this can be done in today’s world of bundled mortgage products?