17. Callable Bonds and the Mortgage Prepayment Option
What is a mortgage? This is a term used to describe a loan taken out by a borrower from a financial institution that uses the borrower’s property as collateral. The borrower is required to make regular payments until the loan is paid in full. A mortgage may also be referred to as a “deed of trust” or “security instrument.”
The term “mortgage” is derived from the French word “mort” which means “death” and “gage” which means “pledge”. This term originated in the Middle Ages when the nobility and the clergy would pledge their lands as security in order to obtain loans from the rich. The pledge of the lands would remain in effect until the loan was repaid. If the loan was not repaid, the lender would take ownership of the land.
In today’s world, mortgages are mainly used to purchase residential properties. When a borrower takes out a mortgage loan, they are required to sign a promissory note and a deed of trust. The promissory note is a document that states the amount of money that the borrower has agreed to pay back and the interest rate of the loan. The deed of trust is a document that serves as a security instrument for the lender. It states that if the borrower fails to make payments according to the terms of the loan, then the lender has the right to seize the property and sell it to recoup their losses.
Mortgages are an important part of the economy as they allow people to purchase homes without having to pay the full price upfront. For the lender, mortgages are a great way to make money as the interest rates charged on mortgages are usually higher than other types of loans.
Mortgages are also a great way for people to build equity in their homes. As the borrower makes payments on the loan, the amount of equity they have in their home increases. This can be beneficial if they decide to sell the home or refinance the loan at a later date.
It is important to remember that taking out a mortgage is a long-term commitment and it is important to understand the terms and conditions of the loan before signing any documents. It is also important to remember that if payments are not made on time, then the lender can take possession of the property.
Key Points
• A mortgage is a loan taken out by a borrower from a financial institution that uses the borrower’s property as collateral.
• The term “mortgage” is derived from the French words “mort” meaning “death” and “gage” meaning “pledge”.
• A mortgage loan typically involves the signing of a promissory note and a deed of trust.
• Mortgages are an important part of the economy as they allow people to purchase homes without having to pay the full price upfront.
• Mortgages are also a great way for people to build equity in their homes.
• Taking out a mortgage is a long-term commitment and it is important to understand the terms and conditions of the loan before signing any documents.
People Also Ask
Q: What is a mortgage used for?
A: A mortgage is typically used to purchase residential properties.
Q: What is the difference between a mortgage and a loan?
A: The main difference between a mortgage and a loan is that a mortgage is secured by the property it is being used to purchase, whereas a loan is not secured by any collateral.
Q: What is a promissory note?
A: A promissory note is a document that states the amount of money that the borrower has agreed to pay back and the interest rate of the loan.
Why is it called a mortgage? – Highest Rated?
Financial Theory (ECON 251)
This lecture is about optimal exercise strategies for callable bonds, which are bonds bundled with an option that allows the borrower to pay back the loan early, if she chooses. Using backward induction, we calculate the borrower’s optimal strategy and the value of the option. As with the simple examples in the previous lecture, the option value turns out to be very large. The most important callable bond is the fixed rate amortizing mortgage; calling a mortgage means prepaying your remaining balance. We examine how high bankers must set the mortgage rate in order to compensate for the prepayment option they give homeowners. Looking at data on mortgage rates we see that mortgage borrowers often fail to prepay optimally.
00:00 – Chapter 1. Introduction to Callable Bonds and Mortgage Options
12:14 – Chapter 2. Assessing Option Value via Backward Induction
42:44 – Chapter 3. Fixed Rate Amortizing Mortgage
57:51 – Chapter 4. How Banks Set Mortgage Rates for Prepayers
Complete course materials are available at the Open Yale Courses website: http://open.yale.edu/courses
This course was recorded in Fall 2009.
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