Interest Rates in Real Estate
Annual percentage rates (APR)
Nominal interest rate charged per period, including fees, but not accounting for compounding - once per year
Solve for EAY on Calculator
period = orange p/yr nominal rate = orange nom % solving for EAY = orange eff%
Default risk
The risk of borrowers defaulting on their mortgage payments
Prepayment risk
The risk of borrowers paying off their mortgages earlier than expected
Real rate of interest
- time preference for consumption - production opp in economy
Comparing nominal annual rates
Avoiding decisions based on comparisons between rates with and without compounding adjustments
Production opportunities in the economy
Competition for funds due to other investment opportunities
Mortgage interest rates
Contract rates of interest for borrowing funds for real estate
Inflation expectation
Expectations of future inflation that directly impact interest rates
Time considerations
Factors such as contractual maturity, early repayment, and compounding that affect the cost of a loan
Risk
Factors such as default risk, interest rate risk, prepayment risk, liquidity risk, and legislative risk
Components of the mortgage interest rate
Factors such as the real rate of interest, risk premiums, and inflation rate
Mortgage funds supply factors
Factors that affect the supply of mortgage funds, such as alternative investments
Effective interest rates
Interest rates that consider fees and/or time effects on the actual cost of a loan -depends on what we are being asked to account for
Truth-in-lending laws
Laws that require lenders to disclose certain information about loans
Loans with fees
Loans that have additional costs such as origination fees and discount points
Adjusting for compounding
Making adjustments to the nominal annual rate to account for compounding intervals
Legislative risk
The risk of government changing laws that affect the collection of mortgage payments
APR disclosure
Requirement for lenders to disclose APR on consumer loans
Interest rate risk
The risk of interest rates changing and affecting the value of mortgages
Borrowers' payment for funds
The amount borrowers are willing to pay for the use of funds
Lenders' acceptance of funds
The amount lenders are willing to accept for the use of funds
Derived demand
The demand for mortgages is dependent on the demand for real estate
Annual percentage yield (APY)
The effective annual yield (EAY) for savings accounts, with possible fees and penalties
Liquidity risk
The risk of not being able to sell a mortgage quickly
Equivalent nominal annual rate (ENAR)
The nominal annual rate of interest compounded at intervals less than one year - useful when we know EAY and want nominal annual rate
Time preference for consumption
The preference to consume now rather than later
Effective annual yield
The yield of an investment after accounting for compounding
ENAR Equation (APR)
[(1+ EAY)^1/m - 1] * m
EAY Equation
[1+(i/m)]^m - 1 i = nominal annual rate m = compounding interval
Difference between Nominal (APR) and EAY
as time intervals become smaller - EAY becomes larger than APR....jumps in beginning large, vs if you were to get closer to continous --> smaller changes
Equation of components of interest rate
i = r + p + f
Components fo mortgage int rate
real rate of interest inflation expectation