In a recent Wall Street Journal Article, Alex Pollock and I proposed using financial defeasance to unlock the mortgage market. Existing home sales volume has been severely depressed since September 2022, when mortgage interest rates increased to more than 6 percent. Homeowners who financed or refinanced their home using a conventional mortgage originated in years when these mortgages had exceptionally low interest rates will face a substantial financial loss should they sell their home.
Many WSJ comments were critical of our abbreviated explanation necessitated by the tight word constraints of a WSJ opinion article. To make amends, I have written a series of short AEI Ideas articles that better explain the proposed mortgage defeasance process as well address tax and legal issues associated with making the proposal operational.
This first in a series of AEI Ideas blog post will explain how financial defeasance can satisfy in full a loan’s contracted payments for less than the remaining outstanding balance on a loan. The explanation requires a rudimentary understanding of present discounted value financial calculations. This post attempts to explain how the financial process works. Some may find this post opaque, but if you work through it, you will see how financial defeasance works.
Say you borrow $1000 today with loan terms that require, at the end of 1 year, a single payment to repay the $1000 borrowed with 6 percent interest. Simple annual interest at a rate of 6 percent requires a payment of $10001.06 or $1060 at year-end. The relationship between a dollar amount today, the interest rate that can be earned on investing those dollars, and the accumulated future cash value of the investment defines a time-value-of-money relationship.
If one can earn 6 percent riskless annual interest, what should one be willing to pay for a riskless promised payment of $1060 1-year from now? Reverse the prior interest rate accumulation relationship: when interest rates are 6 percent, $1060 to be received 1-year hence is worth $1060 ÷ (1.06), or $1000 today because if one invests the $1000 at 6 percent interest, it grows to $1060 at year-end.
Suppose one were promised the same riskless payment of $1060 1-year from now, but the annual riskless interest rate was 7 percent. The future payment of $1060 at year-end would be worth only $990.65 today if interest rates were 7 percent ($1060 ÷ 1.07= $990.65)—because if $990.65 is invested today, at a 7 percent interest rate, the balance will grow to $1060 by year-end.
Typical mortgage contract payment terms do not specify simple annual interest and a single final payment to retire the loan. Conventional 30-year mortgage contracts typically require the loan to be paid back in equal monthly payments with interest compounded monthly. An annual interest rate of 6 percent compounded monthly is equivalent to a monthly interest rate of 0.06 ÷ 12, or ½ percent. While the present-to-future value calculations for a mortgage look more complicated, the same relationship between current balances, interest rates, and future values holds.
To see how mortgage defeasance is possible, first consider a very simplified example of the relationship between, P, the value of the equal monthly payments needed to payoff the principal and interest on a 3-month, $1000 loan when interest rates are 6 percent compounded monthly. The mathematical relationship that determines P is: $1000 = [(P/1.005)+(P/(1.005^2))+(P/(1.005)^3)]. Solving for P, P= $336.67, meaning that three equal monthly payments of $336.67 have a present discounted value of $1000 when interest rates are 6 percent compounded monthly.
After making the first payment, the remaining unpaid balance on the loan is $668.33. Say interest rates increase to 10 percent and so now a risk free security that pays $336.67 per month for the next two month can be purchased for $665.02 = [($336/(1+(.10/12)))+ ($336/(1+(.10/12)^2))]. If you had the cash, and bought this security for $665.02, you could use the cash flows it pays to make the payments on your existing loan. If you did this, you would save $3.31 [$668.33-$665.02] at the beginning of the second month since the income from the new security exactly offsets the remaining payments on your 6 percent 3-month loan. If you followed this discussion, you understand a simple example of how financial defeasance works. The math behind mortgage defeasance is more involved but works in the same way.
The post Mortgage Defeasance I: Compound Interest Makes It Work appeared first on American Enterprise Institute – AEI.
