Managing Default Risk In Home Mortgages
Investors throughout the ages view returns on investment in terms of risk. The greater the risk that investors take the greater the return is expected from that investment. The investment with the least amount of risk these days are treasury securities, because they are free of default risk. Uncle Sam will always pay the interest stream and the face value of the security. With any other investment, investors have to be compensated by a higher return than treasury securities in order for investors to be enticed to undertake such investments.
When an American family decides to buy a home one of the first things it is asked for are the credit scores of the potential buyers. Applicants that have high credit scores are approved and given a low interest loan, while applicants that have low credit scores are rejected or given a high interest loan. Applicants are also asked to disclose their income. Banks like to see low debt to income ratios. Applicants with high to debt to income ratio are charged a higher rate on their mortgage. After the house is bought the new home owner starts a long relationship with the bank, since he then makes his monthly payments for terms of typically fifteen to thirty years.
As soon as the home buyer takes control of the house, the bank incurs the highest risk of default since the home owner has little to lose if he does not make the first month payment. To mitigate that risk the bank asks for a down payment, usually about 10-20% of the home value. The down payment ensures that the home owner is serious and increases the likelihood that the home buyer will pay his first monthly payment since the down payment is much higher than the monthly payment. That down payment acts as collateral and so the remaining 80-90% of the house becomes the face value of the loan. Over time the home owner continues to increase his collateral in the form of the small principle payments made with every mortgage payment paid. This collateral becomes a larger and larger component the monthly payment as the loan nears the end of the term.
The question now arises, if the down payment (collateral) is the guarantee for the riskiest payment (the first payment), why is the bank charging a higher mortgage rate for a low credit score rather than a higher down payment?
The higher mortgage rate charged for low credit score individuals does not reduce the risk, since the default risk on the loan was managed through increased collateral over the life of the loan. The total collateral the bank has is 111-125% (house value/Total loan) before the first month payment and grows to nearly 300,000 % ((all the home equity+ original house value)/ last month principle payment) just before the last payment since almost all of the loan principle has already been paid, assuming the home value did not increase. Instead, the bank is basically charging the home buyer for the future interest income that would not be realized if the low credit rating home buyer were to default or refinance the mortgage. Basically the bank is charging the low credit home owner for prepayment risk (giving up the equity and the value of the home should is a prepayment of the residual loan principle) and reinvestment risk rather than default risk.
The high credit score individual on the other hand is encouraged not to prepay his mortgage by having a low mortgage rate. People default on their mortgages due to adverse personal or macroeconomic conditions. Which could affect both high credit and low credit home owners. Low credit home buyers are as much careful not to lose their home equity as the high credit buyer.
The bank can manage risk associated with default, prepayment and reinvestment risks. The bank simply asks for a higher down payment equal to the present value of the future interest payments minus the equity in a period were the equity value is equal to the previous value of all future interest payment, from both the high credit and low credit home owners. In a low interest environment (4.6%), a potential, home owner for a $100,000 home will deposit $22,089.56 rather than the traditional $20,000 (20% of the home value). The $22,089.56 is equal to the previous value of all interest payments for the 15 year loan ($24,509.97) minus $22,420.41 which represents the previous value of the interest at and beyond the 8th payment (the 8th payment is the payment in which the previous value of future interest payment is equal to the home equity) plus the original down payment of $20,000. The difference between the original down payment and the modified down payment is the collateral ($2,089.56) is the collateral for interest payments between the first and the eighth period. This system works best in low interest environment.
Banks charging higher interest rate for low income or low credit home owners ensure their failure and increase the prepayment through refinancing and default. Charging home owners - those with high and low credit scores- higher down payments and lower interest rates will ensure their seriousness and ensures their success. This strengthens the American family and makes available more disposable income that will help our economy.
Ehaab Jamal, MBA Student, West Chester University, West Chester, PA
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