Lecture 8 Mortgage Choices

Question 1

What are the two choices for a mortgage?

Answer 1

repaying the principal
Setting the interest rate

Question 2

What are the two SMP (Standard Mortgage products)?

Answer 2

Annuitized
Linear

Question 3

How does the annuitized mortgage works?

Answer 3

Stable (nominal) monthly payments
Initially repayments go mostly towards interest.
Ás principal slowly declines, so does the interest, and more and more of repayment goed to paying down principal.
Expected increase in income make unnuitized mortgage more attractive as it will make it easier to pay more later.
Opportunity costs of money: if you can get returns on your money now that compensate for the higher “interest-deduction” payments, annuitized is more favorable

Question 4

How does the Linear Mortgage work?

Answer 4

Stable (nominal) repayments to principal
Decreasing interest leads to decrease in total payment
Linear cheaper due to faster repayment

Question 5

What are the three AMP (Alternative Mortgage product)?

Answer 5

Interest-only mortgage
Endowment and savings mortgages
Investment-based mortgage

Question 6

How does the interest-only mortgage work?

Answer 6

Interest-only mortgage
* Only pay interest, principal remains unchanged
* At mortgage maturity:
– Pay debt
– New mortgage
– Sell house to repay loan
* Pushes payments to future

Question 7

How does the endowment and savings mortgage work?

Answer 7

Endowment and savings mortgages
* Interest-only mortgage + either:
– Life-insurance that pays principal sum at maturity or death
– Savings account that is set up to pay principal sum at maturity
* Interest on savings equal to interest on mortgage debt:
– But interest paid is tax deductible!
* Before tax more expensive, but after tax cheaper than annuitized

Question 8

How does the investment-based mortgage work?

Answer 8

Investment-based mortgage
* Interest-only linked to an investment product, hoping that the profits
match or exceed principal at maturity of mortgage.

Question 9

How to calculate real interest?

Answer 9

real interest = nominal interest – inflation

Question 10

What is the pro and con of the fixed-rate mortgage?

Answer 10

• Often considered the safe option:
  – Payments are stable in nominal terms
• However, it can be risky in terms of real value:
  – If inflation is lower than expected, the fixed nominal rate implies a
  much larger real interest rate (and much higher real NPV)

Question 11

What is the adjustable rate mortgage?

Answer 11

A mortgage were the Nominal interest rate varies over time and
Follows an index that captures cost of borrowing on the market

Question 12

What is the pro and con of the Adjustable rate mortgage?

Answer 12

• Often seen as risky :
  – The nominal payments can vary substantially
• problems for a household with liquidity constraints
• However:
  – Variations in nominal payments to keep real payments stable
  (stable real NPV)
• less risk regarding the real costs of the mortgage

Question 13

When should you choose for the adjustable rate mortgage?

Answer 13

If your income is not volatile
if you have savings
if you are able to borrow
if you have a relatively small loan to income ratio

Question 14

Financial Literacy

Answer 14

Definition :
peoples’ ability to process economic
information and make informed decisions
about financial planning, wealth
accumulation, debt, and pensions

Question 15

What is the overall lesson that can be taken from Lusardi and Mitchell (2014) about financial literacy?

Answer 15

Financial literacy has a causal effect on behavior

Question 16

What has Financial literacy according to the research of Gathergood and Weber (2017) in Wales and England?

Answer 16

Financial literacy has:
* Large positive effect on home ownership
of the young (18-44)
* No effect home ownership for older households
* Lowers the likelihood of holding an AMP

Question 17

Present Bias

Answer 17

Present bias:
Bias towards immediate (rather than delayed) consumption
Associated with a lack of self-control

Question 18

What did the survey of homeowner discover about the present bias with money amounts now or later?
Atlas, Johnson, and Payne, 2017

Answer 18

Present biased owners:
* borrow larger amounts
* are more likely to take a second mortgage
* are more likely to have adjustable-rate mortgage
(different from UK, US ARMs frequently have teaser rates)

Question 19

Boeterente or Pre-payment penalty

Answer 19

Fixed rate mortgages can only be prepaid at a penalty that compensates the lender

Question 20

recourse loans

Answer 20

Lender can go after assets and wages if collateral does not cover debt

Question 21

non-recourse loans

Answer 21

• Lender can only seize collateral
• if Loan > Collateral the loss is for the lender

Question 22

Why Do not immediately default if loan>value?

Answer 22

• House prices may bounce back
• Costs to defaulting
  – Transaction costs
  – Legal costs
  – Reduced access to credit

Question 23

What are the main lessons of people not defaulting strategically ?

Answer 23

Economic drivers have strongest effect
Morals and social norms matter!!!

Question 24

What are two reasons for not re financing?

Answer 24

Inattention
Monitor financial circumstances intermittently instead of continuously
Empirical pattern lowers the probability of refinancing irrespective of incentives to do so (incentives are not known)

Inertia
Additional psychological (or time) costs of taking action
Empirical pattern do not refinance if incentives are not high enough, but immediately do so when they reach a certain threshold (outweighing the psychological costs)

Question 25

Why don’t people refinance when they gouvernment reminds them?

Answer 25

Because they have a trust issue. Why would a gouvernment remind me of something that costs them money?