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Background

I was watching a video about mortgage-backed securities on Khan Academy (ref. this video, skip to 2:32), and something struck me as odd about the way he presented the mortgage model. He presented it as such;

Say you take a loan of $1M with 10% interest, then

  • year 1, you pay $100k

  • year 2, you pay $100k

...

  • year 9, you pay $100k

  • year 10, you pay $100k + $1M

Now, call me an idiot, but that seems like a rough deal. I understand that whatever instance you borrow from will be earning more than $1M back, but that tenth year sounds odd. Is this really how it goes down? Because I think I'd have a hard time paying the $100k/year on my mortgage, while saving another $100k/year for the inevitable tenth year whopper.

Question

Has this model been overly simplified, or is this really how mortgages are paid off?

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The video is from 2007, which predates the financial crisis. This video does simplify many things because it is only the first video of the series.

The mortgage that is being described is an interest only mortgage.

Some borrowers loved interest only mortgage because they were betting that they could sell the property for a profit, while having a smaller than normal monthly payment. It is smaller because none of the payment is going toward principal. But if the price never goes up, then if they ever have to sell they will have a hard time paying off the loan.

Some lenders liked it because it allowed borrowers that didn't make enough to afford the house with a regular mortgage the opportunity to get a loan.

The problem was that the investors never understood the risks, and eventually everything collapsed.

That is why these types of mortgages are rare today.

  • That seems to fit in well with the idea that mortgages would be easier to afford, putting more buyers on the market, which increased the prices. Thanks! – Alec Feb 14 '16 at 23:02
  • Part of the sales pitch for an interest only mortgage was that you could qualify for one at a high interest rate with your bad credit, make payments for a little while, and then refinance later on down the road, which would be easier after your credit improved and the value of the property increased. The problem comes once the value of the property decreases and/or nobody is interested in giving you a new mortgage: you still owe a huge payment when the loan comes due, and worse yet, that payment is for more than the house is worth today. – Zach Lipton Feb 15 '16 at 0:52
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This is the proper payment schedule for a 10 year interest only loan on $1 million at 10%, which is a very high interest rate today. In the US there are many loans available. It is more common for home loans to be fully amortized, where the payments are level over the loan term. The good news is that you don't have the balloon payment at the end. The bad news is that your payments are higher along the way. A fully amortized $1M loan, 10%, 10 years would have monthly payments of $13,215.07. If you pay once per year it would be a little higher than 12 times that, which is $158,580.04. The extra payments reduce the principal, reaching zero principal at the end of the loan. Today, a more likely interest rate would be around 4% and you could get a term of 30 years. With monthly amortization the payment would then be $4,774.15.

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It depends on your terms and conditions.

To start with 10% would be very high interest at the moment, but ignoring that, the example above shows paying interest only payments and the term of the loan being 10 years.

In realistic terms would you be able to borrow $1M? Say you could, your interest rate might be say 4%, so paying interest only you would pay $40k per year for the interest only period, which might be the first 10 years. After that you would start paying more to pay off the loan plus new interest over the next 15 or 20 years (as most mortgage terms are 25 or 30 years, but they can be more or less).

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