The Reality Behind the Foreclosures.

I have to agree with you DP, all I understand is Math.. your formulas are correct. Nice thing about Math is it is Black and White, clear as can be.

PS has got me scratching my head on this topic. Maybe he is bringing a different dimension to the reasoning behind Time and Money and Philosophy to the discussion!

daisypusher wrote:

PrintSmith wrote:

SS109 wrote: Would you loan your money out for 30 years at 5%?
I sure wouldn't. We just took our loan out for 20 years at 4.75$. Only a little more a month, but 10 years less of payments!

Which is why the profit for loaning out the money, the interest, is paid back more swiftly than the principle in the early part of the term in an amortized loan - to give incentive to someone to take the risk of loaning out their money for a 15, 20 or 30 year period of time. Without an incentive to do so, it is likely that no one would be willing to lend out money for such an extended period of time.

No. The only item that affects how much interest is paid is the interest due on the principle for that month. Each month you pay the interest for that month. It is straight math, no other reason than % X principle. This is the same reasoning and calculation whether it is a 1 day old loan or the 29th year of a 30 year loan. The incentive is the same, the percent income is the same.

While it may be true that the total profit (ie interest) paid in total over the 30 years is the same amount regardless of whether the note is amortized or simple interest, with an amortized note the lender receives the bulk of their profit earlier in the term of the note than they would if the note were a simple interest loan. This serves as an incentive to loan out the money long term in that the majority of the profit for doing so yields a high initial ROI and the profit can then be put back to use as capital for additional investment.

As with any other capital venture, a long term mortgage has the largest risk of failure occurring in the earliest years. That is why prior to the government deciding to underwrite the risk by guaranteeing the loans from the treasury of the federal government (Fannie Mae in 1938), long term mortgages typically had some pretty strict requirements that the borrower needed to comply with, if they could even convince someone to lend them such a large amount of money for such an extended period of time. Prior to the creation of Fannie Mae, banks and other financial institutions rarely loaned money out so that someone could purchase a home, which is why housing prices stayed low enough that people could actually save the amount of money necessary to purchase a home. With the government guaranteeing mortgages, more were issued and housing prices increased to the point where it was difficult to save the amount of money necessary to purchase a home, making securing a mortgage more and more necessary to purchase a home, which inevitably led to more government involvement into mortgage lending, more taxpayer guarantees being issued and more risk being taken by lending institutions with other people's money.

So really, when you get down to the brass tacks of it all, the federal government is the source of the problems in the mortgage industry. Had the progressives not sought to interfere in the lending industry in the first place by issuing a federal guarantee to make the lender whole in the event the borrower defaulted on the loan, the lending institutions would have been less eager to risk their venture capital in the mortgage industry. After all, if I have a significant amount of money of my own, and you tell me that regardless of how I manage to lose it it will be replaced, does that not give me incentive to risk that money in ways which I might have been unwilling to risk it before?

Higher ROI in the beginning? ROI is the interest rate and the interest rate is the ROI and neither are changing. If the interest rate is 1%/month the rate of return is 1% per month regardless of whether the loan is 1 day old or 30 years old.

Let's take some numbers out of thin air to illustrate my point daisy.

Let's say that you took out loan for 80% of the cost of purchasing a $250K home for 30 years at 6% and the payment on that loan each month was $1K, meaning you would be paying a total of $360K back for borrowing $200K for 30 years, a $160K profit for the lender over the term of the loan. Of that $1K payment, $100 per month goes to principle and $900 goes to interest in the first year in a amortized loan, so the lender has received an ROI of $10,800 in the first year of the loan. The second year, the interest each month would be say $880 instead of $900. The second year, the ROI comes out to $10,560. In the first 2 years of the loan, or 6.7% of the term, the lender has realized 13.35% of the total profit they will receive for making the loan. In the first 10 years, they will receive well over 50% of the profit due them after only 33% of the term of the loan. That is the ROI incentive I am speaking of. Yes, they will receive a set amount of return on the investment, but they will receive the majority of that return, and be able to reinvest it while the principle amount is still a secured debt, far quicker than they would if they received $445 each month for the 360 months (30 years) of the loan. At a set interest payment, a simple interest loan, in the first 2 years they would realize $11,125 instead of the $21,360 they get in an amortized loan.

This means that during the early term of the note, when default on the loan is most likely, they are receiving the bulk of their ROI, the bulk of their reward for risking their capital by lending it to you. Should you default early in the term, they still have the home securing the principle amount (in this example, $200K) which they would hopefully be able to sell at or near what is still owed in principle in addition to realizing the lion's share of their profit. The risk/reward equation is slanted in their favor, which is why they have the incentive to take the risk of lending you $200K for 30 years.

It seems we have a different definition of ROI.

I agree with this one in which the amount invested is considered:

In finance, rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost (whether realized or unrealized) on an investment relative to the amount of money invested.

http://en.wikipedia.org/wiki/Rate_of_return

With the amount invested going down every month the ROI = interest rate which remains constant.

Think about what you are saying. Money is fungible. Assuming the amount of interest paid is the same for each loan and is at the same rate, by definition the ROI is the same regardless how a person assigns the interest/debt payments/month. By any arbitrary act of calling principle interest or interest principle, if the interest payment for any month does not equal the interest as calculated by the rate (debt owed X interest rate), then that deficient in interest payment is added to the principle. This is all slight of hand. If the person with the so-called straight interest payment plan pays off early - there will be both principle and accumulated interest to be paid off.

I'm obviously failing to make my point daisy, but I can't imagine why.

You and I agree that if a lender gives you a $200K loan for 30 years with a monthly payment of $1000 that the total amount repaid will be $360K, right? The difference between the amount borrowed and the amount repaid would be the interest, or the Return on Investment, in this case, $160K, right?

Under a simple interest computation, where both the principle and interest paid each month remained constant throughout the term, in the first 2 years of the note there would be a total of $11K and change paid in interest, where as an amortized note that amount is over $21K - meaning that the lender receives $10K more in the first two years under an amortized loan than they would in a simple interest scenario. Yes, they will eventually receive all $160K that they are due if the borrower sticks to the scheduled payments in either scenario, the question that provides incentive to lend the money is how quickly will the bulk of that $160K find its way into the pocket of the investor. Under an amortized loan, in the first 10 years of the term they will see over $100K of the total $160K that they have coming to them - about 65% of their eventual profit within the first 33% of the term of the loan. That is a healthy reward during the time of the term with the highest risk of default. The remaining 35% of the profit will be paid out over the remaining 66% of the term, which represents the time in the term where default is less likely.

Investment is all about risk/return. The more of a risk you are taking, the higher the return should be to give you incentive to take the risk. A high risk/low return scenario is not one that any investor seriously considers and only a foolish/desperate borrower offers a high return/low risk opportunity to an investor.

Perhaps a payment/amortization schedule(s) for the two loans would be good for us to come to an understanding. Let's be easy. 10K loan for 1 year with an API of 10%.

Amortized payments would be 879.16/month and the ROI would be 10%/month and 10%/the year.

Payment Interest Principle Balance
1 $879.16 $83.33 $795.83 $9,204.17
2 $879.16 $76.70 $802.46 $8,401.71
3 $879.16 $70.01 $809.15 $7,592.57
4 $879.16 $63.27 $815.89 $6,776.68
5 $879.16 $56.47 $822.69 $5,953.99
6 $879.16 $49.62 $829.54 $5,124.45
7 $879.16 $42.70 $836.46 $4,287.99
8 $879.16 $35.73 $843.43 $3,444.57
9 $879.16 $28.70 $850.46 $2,594.11
10 $879.16 $21.62 $857.54 $1,736.57
11 $879.16 $14.47 $864.69 $871.88
12 $879.16 $7.27 $871.89 -$0.01
$10,549.92 $549.91 $10,000.01

Please show how the simple interest plan compares to this and how the ROI is the same.

Look closely at your chart daisy. In the first 25% of the term, the first 3 months, roughly 50% of the interest is paid, and by halfway through the term that percentage rises to 73%. The investor is receiving the bulk of their return in the early part of the term, which is the incentive to loan the money. Under a simple interest plan, where the return was also $550 but split equally between the 12 months of the term, instead of 50% of the total return being in the hands of the investor by the end of the 3rd month, only 25% of the total return has been paid to the investor. This has the effect of increasing the length of time that is necessary to realize the majority of the profit from lending the money, which acts as a reason not to lend instead of being paid your profit earlier in the term, which acts as an incentive to loan the money.

Sure, you will get $550 in profit by the end of either term, but you will have the opportunity to put that profit back to work for you much sooner in the amortized loan since the majority of that profit is paid sooner. Instead of waiting until halfway through the term to get 50% of your profit, you get 50% of your total profit in half that time, which gives you the ability to reinvest that 50% much earlier in another amortized loan. With simple interest loans, by the time the term is half over and you have received half your profit, with an amortized loan you would have already been 3 months into the next loan and received an additional 50% profit from that loan instead of just being ready to make the second loan from the profits from the first loan.

But you ignore the time value of money. You are attempting to profit at the expense of the investor. The ROI for each month is 10% - yet you ignore this by taking the first slice of the loan payment in regards to the total instead of in regards to the amount invested - that is the fallacy. I doubt if the simple interest payment schedule if forth coming - otherwise you would know the fallacy of your position. So here it is:

Payment Interest Principle Balance ROI
1 $879.16 $45.83 $833.33 $9,166.67 5.50%
2 $879.16 $45.83 $833.33 $8,333.33 6.00%
3 $879.16 $45.83 $833.33 $7,500.00 6.60%
4 $879.16 $45.83 $833.33 $6,666.66 7.33%
5 $879.16 $45.83 $833.33 $5,833.33 8.25%
6 $879.16 $45.83 $833.33 $4,999.99 9.43%
7 $879.16 $45.83 $833.33 $4,166.66 11.00%
8 $879.16 $45.83 $833.33 $3,333.32 13.20%
9 $879.16 $45.83 $833.33 $2,499.99 16.50%
10 $879.16 $45.83 $833.33 $1,666.65 22.00%
11 $879.16 $45.83 $833.33 $833.32 32.99%
12 $879.16 $45.83 $833.33 -$0.01 65.99%
$10,549.92 $549.91 $10,000.01


Please note that the ROI is no longer fixed at 10% during the time frame. This means that if the borrower were to pay off this loan - early pay off fees would need to be applied to ensure that the lender recover the 10% ROI. And of course the lender is more at risk here - they are actually collecting less ROI on the first half of the loan - hoping to get it back through a higher ROI on the second half. And by definition - those payoff fees to yield the 10% ROI would be equal to the difference of principles between this schedule and the amortized schedule + compounded unpaid interest. ROI of 10% must be maintained for the proper comparison. That is the point - 10% ROI is 10% ROI is 10% interest no matter how you put the $$ in the bins.

The reason that the vast majority of people take out a 30 year mortgage is that they can't afford to take out a 15 year mortgage or a 20 year mortgage. They are unlikely, therefore, to be paying off the loan in the early portion of the term, unless they refinance, which is why the lender receives the lion's share of their profit during this time and less of their profit during the last portion of the term.

This is also why mortgages get resold to another investor. The original investor put out $200K for the 30 year loan at 6% with a $1K payment each month for 360 months and would realize a $160K return on that money over the term of the loan. If the original investor sells the loan early in the term to someone else for $230K, the original investor makes a $30K profit very quickly and the new investor will realize the balance of the profit over the remaining term of the loan.

The issue is not how much in total, it is how quickly the profit is realized so that the investor can put that profit back to work earning more profit. By loading the early payments in an amortized loan such that 90% of the money being paid each month is the profit, the investor gets their profit from the deal much more quickly than they get their principle. The principle is secured by what was purchased, the profit depends upon the loan being repaid. By structuring the loan such that the profit is paid first, the principle amount loaned is fairly safe and the bulk of the profit realized from lending the money is paid quickly.

The math is self explanatory daisy. A amortized loan pays a greater percentage of profit in the early term of the loan so that the profit from lending the money is less at risk during the time of the term when default possibility is the greatest. It truly is just that simple. The person or company lending the money wants to be sure that they profit from lending the money out, even in the event that the loan defaults and they have to take back the property that secures the loan. Since default is much more likely in the early years of the term than it is during the last remaining years, this is when the lender wants to receive the majority of the profit.