Mortgages (Quick & Easy Series)

How mortgages work

This is the start of a new series of shorter posts on using the One Lesson to understand some common economic scenarios.

If you want to buy a house, and (like most people) you don’t already have enough money to buy it, you generally have two options:

1. Rent somewhere until you have enough money to buy a house.

2. Borrow money to buy the house, and repay the loan over a long period, perhaps 25 years. This means you can live in the house while you earn the money to pay for it, so you don’t need to pay any rent over that time.

In fact, option 2 isn’t quite borrowing money and then spending it. Instead there’s a 3-way transaction between buyer, seller and bank. Suppose Alice and Bob agree that she will buy his house for £200,000. Here’s how the transaction looks:

Alice takes out mortgage to buy Bob’s house

There are 4 simultaneous actions:

1. The bank adds £200,000 to Bob’s account. (This is a new debt from the bank to Bob).

2. Bob transfers the house to Alice.

3. Alice promises to pay the bank the original £200,000 over 25 years.

4. Alice also promises to pay the bank £155,000 interest over 25 years (a 5% rate).

Changes to Raw Net Worth

Bob’s RNW increases by: £200,000 - the house

Alice’s RNW increases by: the house - £355,000

The bank’s RNW increases by: £155,000.

All in all, it seems a good deal for the bank, especially because it is a secured loan. If Alice fails to repay on time, and a court of law agrees, the bank can “repossess”¹ the house from her, sell it, and use the proceeds to repay the loan.

However, there is a period of 25 years during which Bob can withdraw the £200,000, but Alice hasn’t paid the bank yet. In this case, the bank would have to borrow the cash from, say, another bank, and pay interest to the lender.

Alice has to pay interest, but she doesn’t have to pay any rent for those 25 years.

Recourse vs non-recourse loans

If Alice’s house is repossessed by the bank and sold, chances are that it won’t be for exactly the amount that Alice owes the bank. If there is any money left over from the sale, Alice gets to keep it. But if selling the house isn’t enough to clear the loan, what happens next depends on whether the loan is a recourse loan or non-recourse loan:

• With a recourse loan, Alice still owes the remaining debt.

• With a non-recourse loan, Alice’s debt to the bank is completely cleared once she has surrendered the house to the bank.

Needless to say, if you are thinking of taking out a mortgage, you should find out whether it is a recourse loan first. This is especially true during a housing bubble when house prices are unsustainably high. You wouldn’t want the house’s price to fall but be left with a huge debt to the bank which can’t even be cleared by selling the house.

1. "Repossess” isn’t a great term for what is happening, because the house never belonged to the bank. “Take possession of” is what it means.