Non-investing personal finance issues including insurance, credit, real estate, taxes, employment and legal issues such as trusts and wills
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?
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The mortgage is worth more to the bank than the time-discounted value of all the payments, because it might be paid off early. If you move next year, the value of the mortgage to the bank will be close to the current principal, regardless of the interest rates.
Therefore, if banks allowed homeowners to buy back their mortgages at market value, there would be adverse selection, which would prevent the market from working. Homeowners with $83,000 mortgages would know which were worth $82,000 (planning to move next year) and which were worth $72,000 (planning to stay for ten years), and only those homeowners planning to move soon would buy them back.
Mortgage-backed securities eliminate this risk because they bundle a large number of mortgages into a single security. If there are 100 mortgages in one security, traders don't have to worry that they are buying a single mortgage from a seller who knows that it is worth less than other similar-looking mortgages.
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Thanks, that explains it.
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