Friday, March 29, 2024

The Mortgage Solution and the Refinance Trap: Why the Lender Always Wins with a Mortgage

Mortgage rates have been news for some time now. Coverage about mortgages has recently turned toward news of a potential rate decrease. This potential drop is such a relief to everyone in the real estate market that even President Joe Biden mentioned it in his most recent State of the Union address. Although the reference was a political move and this blog is not political, the President's attempts to use the activity in the real estate market to further his agenda is yet another reminder of the influence that mortgage rates hold on this country.

There are countless prognostications on the "inevitable" drop in mortgage rates, and for good reason. The mortgage market had a treacherous 2023, full of rate hikes from the Fed in response to the record 9.1% inflation rate of June 2022. In its zeal to curb inflation, mortgages became one of the Fed's casualties. The real estate market was noticeably affected, as all activity slowed. This recent article on Investopedia does a great job explaining the past 18 months of mortgage market activity, putting the market into historical perspective. At this point, any news of relief in the mortgage market is seen as a beacon of hope.  The fact that the Fed has succeeded in lowering inflation, as indicated by graph below, only adds to the anticipation that good news is on the horizon.

Statistic: Monthly 12-month inflation rate in the United States from February 2020 to February 2024 | Statista
*Property of Statista

The news of lower inflation is sweet music to the country's ears. Real estate professionals in particular love to hear about lower inflation, because it is the precursor to lower interest rates and everyone loves lower interest rates. Borrowers love lower mortgage rates because they lower mortgage payments and allow for increased purchasing power. Property owners appreciate a lower interest rate market, because it increases the number of purchasers available in the market, it makes closing a deal faster and more seamless and it allows them to purchase more with the money that they gain from selling their property. There is, however, a less intuitive question: why do lenders prefer a lower interest rate market? Thankfully, there is a simple answer—although lower rates mean less interest on each mortgage, lower rates increase volume. More importantly, even at low interest rates, with mortgages, the lender always wins and wins big.

Big Windfall

A 30-year mortgage carried to term is indeed one of the best investments that exists. Calculated using the simplest terms possible, a traditional mortgage paid to term can yield triple digit percentage returns in interest alone, as outlined in the table below. A mortgage paid to term at 6% or higher will cause the borrower to pay more than double the principal. Numbers like this are enough to make any investor run to invest in mortgages or become a lender themselves, but the gains become more modest when considering inflation.

$300,000 Mortgage

Mortgage Rate

Total Paid Over Loan Term

Total Interest Paid Over Loan Term

Interest Paid as a Percentage of Principal

Present Value of Total Paid at 4% Inflation

Present Value of Interest Paid at 4% Inflation

Interest Paid as a Percentage of Principal at 4% Inflation










































 *Property of the Real Estate Think 

The table above predicts the present value of a $300,000 30-year mortgage paid to term, assuming static 4% inflation. Although the historical US inflation rate is 3.3%, and inflation hit a peak of 9.1% in June of 2022most recent inflation statistics put current inflation around 3.2%. In light of these figures, the 4.0% estimation used is conservative. Once adjusted, the percentages are certainly lower, as money devalues over time, but they are by no means unattractive. Lending is a lucrative business and so ingrained in American culture that most borrowers do not understand the trade-off that they are making and those that do, do it anyway.

There are few purchases that can justify paying an extra 50% for them and fewer are worth paying for them twice. That said, appreciation more than mitigates the costs of borrowing for a property purchaser. Real estate returns average between 9.5% and 10.6%, depending on the type investment. A mortgage, therefore, is a much an attempt to capture some of the appreciation of a property as it is a loan to facilitate acquisition. Savvy investors, however, have learned to mitigate the amount of appreciation that a lender can capture through increased downpayments, prepayments, refinancing and a myriad of other methods. In light of these attempts at managing mortgage expense, the spread offered above market, the liquidity of the instrument, the relatively high priority of rights to the property and the overall payments structure make a well-vetted mortgage a great investment for the lender.

The Spread

Mortgages are designed to make money for their lenders and the mortgage market ensures that they do so. Mortgages typically trade at a spread over the yields of 10-year Treasury bonds, abbreviated as 10-yr T-bills. This is a well-known, often-quoted, fact. The aspect of mortgage-10-yr T-bill relationship that is less discussed publicly is that mortgage spreads and T-bill yields have an inverse relationship. This means that as mortgage rates drop and volume increases, the amount of extra percentage points lenders charge over a T-Bill yield increases. Conversely, as T-Bill yields increase, spreads decrease, but as shown above, the amount of interest paid increases, as the mortgages given in these markets have higher rates. Furthermore, these rates are locked in for up to 30 years, meaning that if paid to term, a lender will receive the higher rate, even if the yield of the 10 yr T-Bill drops to 2%. In this way, mortgage lenders profit in any interest rate market--either from volume and increased spread, when rates are low or from increased interest when rates are high. Interestingly, now is a particularly advantageous time for mortgage lenders. Mortgage spreads seem to remain high, despite T-bill yields dropping. This is a unique situation that makes lending more lucrative and borrowing more expensive in the current market.

The Liquidity

It is no secret to readers of this blog that mortgages are easily bought and sold on the secondary market. There are two types of secondary markets for mortgages--private and institutional. The private secondary market consists of the local note buyers in a community that acquire individual private mortgages. The institutional secondary market is the place where mortgage lenders sell the bundle of mortgages they originate to banks, different types of funds and other entities in exchange for more cash to lend. It's also the place where different financial institutions trade whole loan portfolios. There are several articles about the secondary mortgage market on this blog, which can give more context on its purpose and activity. The fact remains, however, that there is an active market in which buyers and sellers are readily trading mortgages. That said, there is no question that one of the most cost-effective ways to transfer a property is by selling its mortgage. Doing so carries low property risk and the promise of cashflow. Interestingly, since most mortgages are recorded with land records, a mortgage transfer theoretically could take the same amount of time as closing a house for cash. Mortgage transactions, however, are usually much faster than property closings, because the due diligence process for a mortgage is less involved than the process of vetting a property.

High Priority Rights

The reason that a transfer of a mortgage can be considered a transfer of a property is that primary mortgages, if originated properly, are either in the first lien position or, in title theory states, are held by the lender in a trust for the benefit of the borrower. Essentially, this means that holding a mortgage is like the lender having a right of first refusals that the borrower pays to maintain. If the borrower is unable to pay, the primary mortgage holder has the strongest ability to claim the property that wipes out any junior lien holders upon execution. The rights of the primary mortgage holder can only be trumped by the local government, who can wipe out any lien holder, including a mortgage holder, for unpaid taxes. Holding a primary mortgage is as close as you can to the property without owning it.

Payment Structure

With a mortgage, the lender gets paid first. This is because all mortgages are front-loaded with interest until the reversion point--the point at which most of the payment stops going to pay down interest. The time it takes for a mortgage payment to consist of more principal paydown than interest is listed in the table below and rises as the interest rate of the mortgage increases. Viewed from this perspective, the effect of a higher interest rate is not merely increased monthly payments, but also significantly increased interest paid overall and a longer period during which interest dominates the monthly payment. The length of time before reaching the reversion point can further be reduced by choosing a shorter mortgage term at the outset.

Mortgage Rate

Reversion Payment

Number of Years Until Reversion
















*Property of the Real Estate Think 

The Refinance Trap

Keeping in mind the reversion point of a mortgage, the reason lenders incentivize a refinancing, even at a lower rate, is to reset the time period in which the mortgage payments are dominated by interest. Not only are these payments reset, but the lender is able to charge additional fees at closing and is guaranteed an extended payment period. In every sense, a traditional refinance is a windfall for a lender and a trap for a borrower, to be mitigated by tax benefits and better investments. Although many refinancing owners are enticed by the prospect of tapping into a property's equity through a refinance, a home equity line of credit (HELOC) can offer the same equity access without extending the life of the mortgage. HELOC's are not without their own costs, as they are typically offered at a higher interest rate that floats. Two articles that do a great job at comparing HELOC's to home equity loans and traditional mortgages are this one by and this one by

Ultimately, this article can be read in two ways--it can be viewed as an overture to investors, explaining the benefits of becoming a real estate lender or investing mortgages or it can be seen as an advisory to borrowers about the lopsidedness of the mortgage instrument in favor of the lender. Either way, one thing remains true--with mortgages, the lender wins. 

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