This isn’t something most folks think about. When an investor (say Fannie Mae or Freddie Mac, for example) buys your mortgage, how much are they willing to pay for it, and why?
If you have a $100,000 mortgage you would think the lender would pay $100,000, right? It turns out that isn’t so. Here’s why – ask yourself the question “What exactly is the investor buying?”
We have to turn around our thinking to wrap our minds around this one; go to the other side of the table, so to speak. The investor isn’t buying $100,000 in cash. Rather, the investor is buying the right to collect payments from you for the next 30 years. Since the payments are pre-determined then the value of those payments can be determined by applying the yield (interest rate) that the investor wants to earn.
The mortgage has a principal balance of $100,000 at an interest rate of 4.25% with 30 years left to run. The monthly payments on the mortgage are $491.94. The lender asks “What is the yield on my investment that I need to make in order for me to invest in this mortgage?” If it is a brand-new, unblemished mortgage, the answer is an interest rate lower than the note rate, since the lender presumably wanted to sell the loan at a profit. Here’s how the math works out:
Let’s use Excel to calculate the value of an income stream. We do this using a present value function. 1 First, let’s ask what the value of monthly payments of $491.94 for 30 years at a yield of 4.250% would be. It should work out to $100,000, since this is the payment, term and interest rate for the mortgage in questions, and it does.
Now let’s say that the investor’s required yield is about 0.250% lower than the going rate for a zero-point loan. (This varies, but it’s close today.)
If so, then the investor would want to earn 4.000% in this example. Since the payments are set, all we have to do is use the present value function to calculate the value. It turns out that the mortgage would be worth about $103,000 to the investor, which is about right in today’s market. The lender that made the loan, therefore makes about $3,000 in net profit on the $100,000 loan.
But sometimes (after the fact) the investor that bought the loan decides it wasn’t underwritten properly, and forces the original lender to buy it back. Now the original lender owns your mortgage again, but it isn’t really in the business of keeping loans. They want to sell this loan off in order to generate cash to make more loans.
So what is your mortgage worth now? Believe it or not there is something called a “scratch-and-dent” market for loans that had to be taken back. See this blog for an explanation.
A “Scratch-and-dent” investor wants to earn a higher yield on this investment; after all, it’s bruised. How much more? 1% to 1.5% is common, although it varies a great deal. If we assume that the scratch-and-dent investor wants to earn a premium spread of 1.25% on its investment, then it needs to earn 5.500% (4.250% + 1.250% = 5.500%) on the deal. What’s that worth? About $86,600 as it turns out.
So the original lender thought they were going to make a profit of $3,000, but instead have now taken a loss of $13,400, not to mention the hassle and risk of having to take the loan back and sell it again.
How does this affect you? It doesn’t. The terms of your loan never change, and through this whole process you might not even know this happened in the background. You might even still be making your payments to the same lender.
The salient point is that the value of your mortgage to an investor has little to do with the principal loan amount. Rather, it is determined by the amount of your monthly payment, the number of payments you have left to make, the yield the investor needs to make in order for the investment to make sense, and the quality of the documentation and underwriting of your file.
Suddenly, nit-picking underwriters make a little more sense.
Casey Fleming, Author of The Loan Guide: How to Get the Best Possible Mortgage (Available on Amazon)
Mortgage Advisor, C2 Financial Corporation
NMLS 344375 / BRE 00889527
1 Present Value Function: =PV(Interest rate,# of periodic payments,-monthly payment,0,0) (For Excel geeks like me)