The Easiest Hardest Question Ever

I was reading Felix’s post, recently (I know, I’m behind on everything… I’m posting on that soon too), where he cites a Tanta piece on negative amortizing loans. And it prompted me to have a very specific memory.

Here’s my email to Felix…

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Subject: Here’s something funny-scary …

… that your post on option ARMS got me thinking about. No one, and I literally mean NO ONE, who works in securitized products knows very basic things about the loans, as you touched on. But the people securitizing the loans and selling the bonds don’t know very basic things that fall under the “you should be shot for not knowing something this basic” category… Here’s what I asked a whole bunch of these master’s of the universe and none of them knew the answer, they all guessed.

“When I, as an individual who has a mortgage on my home, have a fixed rate amortizing loan on a thirty-year amortization schedule, and I send in a curtailment (excess principal payment that doesn’t pay off the loan but reduces the principal balance faster than scheduled) what happens to all the subsequent payments?”

Here’s why this is tricky…

1. If you curtail the loan then your interest payment reduces. However, this means your payments are no longer “level” … They change from month to month. This is because amortization schedules set based on simple interest computation (rate*loan balance) but the principal is set to keep the payments level. When you curtail the loan, you destroy this balance.

2. If your interest payment reduces once, but the overall payment doesn’t change, then you have a loan that starts to amortize much faster than before. Why? Well, the bank can’t charge you interest for that month on a principal balance that is lower, right? So if your payment is “x” and you paid off 5% of your loan, because the interest portion of your payment is 5% lower, if the payment hasn’t changed that money that would have gone to interest on the paid off amount goes to principal repayment. This compounds the same problem for next month’s payment.

3. No one was aware of loans being recast. It doesn’t seem to be the case that loans are recast once someone sends in more than their payment, and it also doesn’t seem to be the case that loans are recast on any sort of schedule (annually, for example). Not a single person thought this happened.

Most common answer was “principal balance goes down” …. And once the details were asked? One usually got a hand wave and an answer of “Curtailments are so rare, this is unimportant.” Even the people modeling the actual cashflows didn’t understand what happens to loans when curtailments come in. They would model it as a partial prepayment of the pool, but not alter anything else (after all, curtailments are rare! why bother modeling them correctly?). Ha!

-DJT

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I did call some mortgage companies and it seems they do “turbo” the loan, essentially, by keeping payments level and applying more to principal … But this, obviously, makes it les than a 30-year loan. However, some mortgage companies will allow you to recast the mortgage totally for payments that are large enough.

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