This case study is about Mortgage Financing. Carson Company currently has a mortgage on its office building through a savings institution. It is attempting to determine whether it should convert its mortgage from a floating rate to a fixed rate. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. The fixed rate that it would pay if it refinances is higher than the prevailing short-term rate, but lower than the rate it would pay from issuing bonds.
- What macroeconomic factors could affect interest rate and therefore affect the mortgage refinancing decision?
- If Carson refinances its mortgage, it also must decide on the size of a down payment. If it uses more funds for a larger down payment, it will need to borrow more funds to finance its expansion. Should Carson make a minimum down payment or a larger down payment if it refinances the mortgage? Why?
- Who is indirectly providing the money that is used by companies such as Carson to purchase office buildings? That is, where does the money that the savings institutions channel into mortgage come from?
In this case there are three questions. The answers of the questions are given bellow:
Economic factors that affect the interest rates and refinance decisions are given below:
The risk-free rate of interest is driven by inflationary expectations (INF), economic growth (ECON), the money supply (MS), and the budget deficit (DEF).
Inflationary Expectations: An expectation of higher inflation puts upward pressure on interest rates and therefore on the required return on mortgages. Conversely, an expectation of lower inflation puts downward pressure on interest rates and therefore on the required rate of return on mortgage.
Economic Growth: An increase in economic growth can cause an increase in the risk-free interest rate and therefore an increase in the required rate of return on mortgages and decline in mortgage prices. Conversely, a decrease in economic growth can cause a decrease in the risk-free interest rate and therefore a decrease in the required rate of return on mortgages and an increase in mortgage prices.
Money Supply Growth: A relatively high level of money supply growth tends to place downward pressure on the risk-free interest rate (assuming that it does not increase inflation expectations) and therefore places downward pressure on the required rate of return on mortgages and upward pressure on mortgage prices. A relatively low level of money supply growth tends to place upward pressure on the risk-free interest rate and therefore puts upward pressure on the required rate of return on mortgages; the results is lower mortgage prices.
Budget Deficit: An increase or decrease in the annual budget deficit charges the federal government’s demand for funds and can affect the risk-free rate. In 1998, 1999, and 2000, the U.S. government had a budget surplus, which reduced the government’s overall demand for loanable funds. This placed downward pressure on the risk-free rate and on the required rate of return on mortgages and increased the price of mortgages.
The factors discussed in above are affected the interest rate and the refinance decisions.
- Down payments make a difference; the Carson Company should make a large down payment. Because if Carson make large down payment, lenders may be more lenient with their qualifying ratios.
For example, a person with a 20 percent down payment may be qualified with the 33 percent housing expense ratio, while someone with a 5 percent down payment is held to the stricter 28 percent ratio.
The flow of funds is shown by the following figure.