UGBA 180 Chapter Notes - Chapter 4: Amortizing Loan, Interest Rate Risk, Prepayment Of Loan
22 May 2018
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Chapter 4: Fixed Interest Rate Mortgage Loans
• Derived demand: demand for mortgage loans is determined by the demand for real estate
• Charges in addition to the loan: discounts, origination fees, prepayment penalties, or prepaid interest
• Lenders also consider returns and the associated risk of loss on alternative investments in relation to returns
available on mortgages
• Real rate of interest: minimum rate of interest that must be earned by savers to induce them to divert the use of
funds from present to future consumption
• The nominal rate of interest is partially determined by the real interest rate plus a premium for the expected rate of
inflation
• Interest rates and risk
o Default risk: likelihood that lenders must charge a premium or a higher rate of interest to offset possible
loan losses
o Iterest rate risk: uertait of toda’s orld aout the future suppl of saigs, dead for housig, ad
future levels of inflation; unanticipated interest in the future
o Prepayment risk: when the loan is paid back when interest rates fall below the loan contract rate
o Liquidity risk: securities that are easily sold and resold in well-established markets will require lower
premiums
o Legislative risk: regulations that affect tax status of mortgages, rent controls, state and federal laws that
affect interest rates
• i = r + p + f
o r = risk
o p = premium
o f = anticipated inflation to earn the real rate of interest that is competitive with real returns
• Accrual rate: amount of interest accrued and owed to the lender at the end of the month/period
• Pay rate: ratio of the payments and the loan amount
• Interest only/zero amortizing loan: pay rate is equal to the accrual rate and the loan balance at maturity is equal to
the amount borrowed; loan must be fully repaid at maturity
• During the last months of the loan, the accrued interest declines sharply and amortization increases (decreases the
loan balance)
• Constant payment mortgage (CPM)
• Types of loans
o Fully amortizing: highest monthly payment
o Partially amortizing
o Interest only
o Negative amortizing: lowest monthly payment; highest risk
• Regardless of when loans are repaid (maturity or before), each loan pattern will yield the same amount to the
lender, but the lender can charge additional financing fees
• Loan fees
o Loan closing costs (loan fees)
▪ Loan origination fees: covers expenses incurred by the lender for processing and underwriting loan
applications, preparing loan documentation/amortization schedules, obtaining credit reports, and
other expenses
• Costs are charged when the loan is made, separate from the mortgage payments because of
ases i hih loas are paid ak earl ad leders a’t reoer the fied osts of loa
origination
▪ Discount fees (points): purpose is to adjust the yield on a loan
• Buying down the interest rate: when the borrower will buy down the interest rate by paying
discount points to the lender
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