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How does a refinance allow a mortgage to be repaid?

What do banks do with “Repaid Principal”?What's the term for consumers not being able to pay their mortgage?Literature Request: how does the house quality distribution change endogenously over time?Conforming mortgage loan limits by county and yearHow does the fractional reserve banking system work?How much do real-estate prices correlate with apartment rental prices?Authoritative Books on Subprime Mortgage CrisisHow are fund managers usually compensated against benchmark?How does hedging using futures work?Should housing be considered a form of capital for the purpose of capital gains taxation?

1

$begingroup$

A textbook I'm reading states (talking about the years leading up to the financial crisis):

As long as housing prices increased, these mortgages were secure: the
borrower
rapidly accumulated equity in the house that could be taken out in a refinance,
allowing the mortgage to be repaid.

How would this work exactly? I know that many people took out home equity loans, but I'm not exactly sure how accumulated equity would end up making liabilities easier to pay back.

finance housing

share|improve this question

asked 5 hours ago

VastingVasting

275

$endgroup$

• 
  
  
  

  
  

  
  
  
  
  
  

  
  $begingroup$
  What kind of mortgages are being referred to in the text? From the context, it sounds like subprime.
  $endgroup$
  – Brian Romanchuk
  3 hours ago
  

  
  
  
  

add a comment | 

1

$begingroup$

A textbook I'm reading states (talking about the years leading up to the financial crisis):

As long as housing prices increased, these mortgages were secure: the
borrower
rapidly accumulated equity in the house that could be taken out in a refinance,
allowing the mortgage to be repaid.

How would this work exactly? I know that many people took out home equity loans, but I'm not exactly sure how accumulated equity would end up making liabilities easier to pay back.

finance housing

share|improve this question

asked 5 hours ago

VastingVasting

275

$endgroup$

• 
  
  
  

  
  

  
  
  
  
  
  

  
  $begingroup$
  What kind of mortgages are being referred to in the text? From the context, it sounds like subprime.
  $endgroup$
  – Brian Romanchuk
  3 hours ago
  

  
  
  
  

add a comment | 

$begingroup$

A textbook I'm reading states (talking about the years leading up to the financial crisis):

As long as housing prices increased, these mortgages were secure: the
borrower
rapidly accumulated equity in the house that could be taken out in a refinance,
allowing the mortgage to be repaid.

How would this work exactly? I know that many people took out home equity loans, but I'm not exactly sure how accumulated equity would end up making liabilities easier to pay back.

finance housing

share|improve this question

asked 5 hours ago

VastingVasting

275

$endgroup$

share|improve this question

asked 5 hours ago

VastingVasting

275

share|improve this question

asked 5 hours ago

VastingVasting

275

asked 5 hours ago

VastingVasting

275

asked 5 hours ago

VastingVasting

275

2 Answers
2

active

oldest

votes

1

$begingroup$

Say you buy a house for $100. This is paid with:

• A $10 down payment (from your own cash). (This is your equity.)


• A $90 loan from a bank at 10% annual interest. (We call this a mortgage loan or more simply a mortgage.)

Notice you're paying a relatively high interest rate of 10% on your mortgage, perhaps because the bank is not very confident that you'll be able to repay the loan.

Say that overnight, the value of the house rises by $50 to $150. Now your equity has also risen by $50, from $10 to $60. You can now refinance your mortgage and ask the bank to lower the interest rate on your loan, say to 5%. You are certainly happy to do this refinancing because you'll pay a lower interest rate. And the bank might be willing to oblige because it is now more confident that you'll repay the loan.

share|improve this answer

edited 2 hours ago

answered 2 hours ago

Kenny LJKenny LJ

6,06321945

$endgroup$

add a comment | 

1

$begingroup$

Let's say that you have a house that you buy for $P$ dollars. You have a mortgage of $M$ dollars. There is a change in the price of housing of $r$ percent. Assuming no transaction costs, the home owner's equity, the value of the house after selling it and repaying the mortgage is then:
$$ max[(1+r)cdot P - M, 0]$$
because if the mortgage is worth more than the house they can default, and this option makes it so the household has equity of at least zero. There is a second reason a household might default, that they are unable to pay their mortgage. The first reason is called strategic default and the second non-strategic default. In good times, when $r$ is positive, the household has positive home equity and no reason for strategic default. If they are unable to make their mortgage payments (non-strategic default), they can sell their house. This allows them to pocket their home equity, protect their credit, and repay their loan.

In reality, there are complications. The lasting damage to credit scores of a default, the possibility of recourse on a mortgage, losses in house value from foreclosure, and transaction costs all complicate this picture some. But the general idea still holds. Rising house prices give households with cash flow problems the ability to sell their houses rather than default. So the strategic defaulters have no reason to default and the non-strategic defaulters can sell instead of default. This lowers default risk substantially.

share|improve this answer

edited 1 hour ago

answered 3 hours ago

BKayBKay

12.3k22458

$endgroup$

add a comment | 

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1

$begingroup$

Say you buy a house for $100. This is paid with:

• A $10 down payment (from your own cash). (This is your equity.)


• A $90 loan from a bank at 10% annual interest. (We call this a mortgage loan or more simply a mortgage.)

Notice you're paying a relatively high interest rate of 10% on your mortgage, perhaps because the bank is not very confident that you'll be able to repay the loan.

Say that overnight, the value of the house rises by $50 to $150. Now your equity has also risen by $50, from $10 to $60. You can now refinance your mortgage and ask the bank to lower the interest rate on your loan, say to 5%. You are certainly happy to do this refinancing because you'll pay a lower interest rate. And the bank might be willing to oblige because it is now more confident that you'll repay the loan.

share|improve this answer

edited 2 hours ago

answered 2 hours ago

Kenny LJKenny LJ

6,06321945

$endgroup$

add a comment | 

1

$begingroup$

Say you buy a house for $100. This is paid with:

• A $10 down payment (from your own cash). (This is your equity.)


• A $90 loan from a bank at 10% annual interest. (We call this a mortgage loan or more simply a mortgage.)

Notice you're paying a relatively high interest rate of 10% on your mortgage, perhaps because the bank is not very confident that you'll be able to repay the loan.

Say that overnight, the value of the house rises by $50 to $150. Now your equity has also risen by $50, from $10 to $60. You can now refinance your mortgage and ask the bank to lower the interest rate on your loan, say to 5%. You are certainly happy to do this refinancing because you'll pay a lower interest rate. And the bank might be willing to oblige because it is now more confident that you'll repay the loan.

share|improve this answer

edited 2 hours ago

answered 2 hours ago

Kenny LJKenny LJ

6,06321945

$endgroup$

add a comment | 

$begingroup$

Say you buy a house for $100. This is paid with:

• A $10 down payment (from your own cash). (This is your equity.)


• A $90 loan from a bank at 10% annual interest. (We call this a mortgage loan or more simply a mortgage.)

Notice you're paying a relatively high interest rate of 10% on your mortgage, perhaps because the bank is not very confident that you'll be able to repay the loan.

Say that overnight, the value of the house rises by $50 to $150. Now your equity has also risen by $50, from $10 to $60. You can now refinance your mortgage and ask the bank to lower the interest rate on your loan, say to 5%. You are certainly happy to do this refinancing because you'll pay a lower interest rate. And the bank might be willing to oblige because it is now more confident that you'll repay the loan.

share|improve this answer

edited 2 hours ago

answered 2 hours ago

Kenny LJKenny LJ

6,06321945

$endgroup$

share|improve this answer

edited 2 hours ago

answered 2 hours ago

Kenny LJKenny LJ

6,06321945

answered 2 hours ago

Kenny LJKenny LJ

6,06321945

answered 2 hours ago

Kenny LJKenny LJ

6,06321945

1

$begingroup$

Let's say that you have a house that you buy for $P$ dollars. You have a mortgage of $M$ dollars. There is a change in the price of housing of $r$ percent. Assuming no transaction costs, the home owner's equity, the value of the house after selling it and repaying the mortgage is then:
$$ max[(1+r)cdot P - M, 0]$$
because if the mortgage is worth more than the house they can default, and this option makes it so the household has equity of at least zero. There is a second reason a household might default, that they are unable to pay their mortgage. The first reason is called strategic default and the second non-strategic default. In good times, when $r$ is positive, the household has positive home equity and no reason for strategic default. If they are unable to make their mortgage payments (non-strategic default), they can sell their house. This allows them to pocket their home equity, protect their credit, and repay their loan.

In reality, there are complications. The lasting damage to credit scores of a default, the possibility of recourse on a mortgage, losses in house value from foreclosure, and transaction costs all complicate this picture some. But the general idea still holds. Rising house prices give households with cash flow problems the ability to sell their houses rather than default. So the strategic defaulters have no reason to default and the non-strategic defaulters can sell instead of default. This lowers default risk substantially.

share|improve this answer

edited 1 hour ago

answered 3 hours ago

BKayBKay

12.3k22458

$endgroup$

add a comment | 

1

$begingroup$

Let's say that you have a house that you buy for $P$ dollars. You have a mortgage of $M$ dollars. There is a change in the price of housing of $r$ percent. Assuming no transaction costs, the home owner's equity, the value of the house after selling it and repaying the mortgage is then:
$$ max[(1+r)cdot P - M, 0]$$
because if the mortgage is worth more than the house they can default, and this option makes it so the household has equity of at least zero. There is a second reason a household might default, that they are unable to pay their mortgage. The first reason is called strategic default and the second non-strategic default. In good times, when $r$ is positive, the household has positive home equity and no reason for strategic default. If they are unable to make their mortgage payments (non-strategic default), they can sell their house. This allows them to pocket their home equity, protect their credit, and repay their loan.

In reality, there are complications. The lasting damage to credit scores of a default, the possibility of recourse on a mortgage, losses in house value from foreclosure, and transaction costs all complicate this picture some. But the general idea still holds. Rising house prices give households with cash flow problems the ability to sell their houses rather than default. So the strategic defaulters have no reason to default and the non-strategic defaulters can sell instead of default. This lowers default risk substantially.

share|improve this answer

edited 1 hour ago

answered 3 hours ago

BKayBKay

12.3k22458

$endgroup$

add a comment | 

$begingroup$

Let's say that you have a house that you buy for $P$ dollars. You have a mortgage of $M$ dollars. There is a change in the price of housing of $r$ percent. Assuming no transaction costs, the home owner's equity, the value of the house after selling it and repaying the mortgage is then:
$$ max[(1+r)cdot P - M, 0]$$
because if the mortgage is worth more than the house they can default, and this option makes it so the household has equity of at least zero. There is a second reason a household might default, that they are unable to pay their mortgage. The first reason is called strategic default and the second non-strategic default. In good times, when $r$ is positive, the household has positive home equity and no reason for strategic default. If they are unable to make their mortgage payments (non-strategic default), they can sell their house. This allows them to pocket their home equity, protect their credit, and repay their loan.

In reality, there are complications. The lasting damage to credit scores of a default, the possibility of recourse on a mortgage, losses in house value from foreclosure, and transaction costs all complicate this picture some. But the general idea still holds. Rising house prices give households with cash flow problems the ability to sell their houses rather than default. So the strategic defaulters have no reason to default and the non-strategic defaulters can sell instead of default. This lowers default risk substantially.

share|improve this answer

edited 1 hour ago

answered 3 hours ago

BKayBKay

12.3k22458

$endgroup$

share|improve this answer

edited 1 hour ago

answered 3 hours ago

BKayBKay

12.3k22458

answered 3 hours ago

BKayBKay

12.3k22458

answered 3 hours ago

BKayBKay

12.3k22458