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MODELING MORTGAGE RISKS The word mortgage is derived from french law and means death pledge.

That means that pledge comes to an end either with paying off the obligation or the property is sold off to recover the debt. Simply it means that an amount of money is advanced to purchase a property and in case the money cannot be recovered the property is sold off to recover the same. According to USDTA around 70 percent of native born Americans own their own homes, with 67.6 percent of naturalized citizens and 34.9 percent of non-citizens in the US being homeowners. About 70 percent of owner occupied homes in the United States are currently mortgaged. Thus for a normal person with minimal knowledge of Finance and Economics, planning a mortgage is not easy. The paper is directed to help that segment to understand their mortgage risk. Statement : One can plan a mortgage in such a fashion that he becomes indifferent towards the macro economics factors such as Interest Rates, Economic Slowdowns, Currency Rates etc. Understanding Risks : Primary aim is to understand the risks involved in taking a mortgage. The following are the questions one must ask before taking a mortgage. 1) 2) 3) 4) How much I want to borrow ? Where will I use the money ? From whom to borrow ? What is my RISK EXPOSURE ?

Solutions : The question number 1 and 2 are addressing different aspects of the same problem. A person has to make a decision as to what he wants to purchase. Whether such a purchase is prudent and will maximize his utility. Now how I interpret maximization of utility is relevant here . For me utility means attainment of satisfaction from a purchase provided I prudently use my money to make that purchase. The utility derived from a product must be as high as it can be as I have given up the utility of the money I used to purchase that product. For example if my needs are satisfied from a humble condo I will non purchase an extravagant house just to show off. That is not prudent, rather it is an emotional decision. Why I say so ? Because the extra space is not generating any utility and is not providing me with any extra income rather it increased my expenditures. Now after answering the second question, the first question becomes relevant as to how much I need to borrow. Let me explain this with a case study : Suppose Annie and Mike get married and they want to make future plans. They came to me and asked for my advice. The primary question that I asked them is how much do you earn every week. Both were working at the same place and said that they get 280 $ per week. So there total cash inflow is $ 560 per week. I asked them how much you spend on essential commodities. Those expenses that cannot be curtailed in any way, such as food, electricity, mobile bills, other general utility etc. The said that there monthly expenses on essential commodities is $ 250. As they were newly married I advised them to consider making some savings for future. So we come to a conclusion that en extra 100$ will be invested every week so as to cover future expenses. Thus after covering all these we are left with $ 210 to work with. Now they wanted to plan a house worth 65000 $ which they want to buy in 5 years. Now they want me to plan there extra 210$ in such way that they need to buy as less as possible. If they are highly risk averse I will advise them to invest in a fixed deposit account with a bank. It is the safest way to keep your money that why there is no risk and less return. The deposit rate is 3.55 % and they decided to deposit it on monthly basis. Thus every month they deposit 840$ and in a year they

deposit 10080$. In five years time they deposit 50400$. Along with this they have earned an interest of 4800 $. ( Please do not go in the calculations as there are many websites that can help one to get the results). Thus planning early they now had only a minimal sum to borrow and that is 8900 $. That can be repaid by allocation of 50 $ in a plan of 30 years @ 4.5% and taking into account 1200/year home insurance and property tax and other costs amounting to $ 3000/ year. Thus they get a surplus savings of 160 $. One will say that inflation will rise more than the minimal wages. Then also if we have the advantage of early planning then we can use the interest that are gathered use them in more risky adventures that can get us returns up to 8% such as stocks or we can still have time to adjust our savings and purchase some risky assets and increase our returns and rising inflation means there will be a rise in companies profits in the economy. Thus the primary mantra becomes PLAN EARLY The next important question that is to be answered is what should be the source of procurement of loans. The policy should be to Choose Wisely From a Pool of Options. If some one asks me which one to chose than as I would suggest that depending on our planning as described above we should choose one that best choose us. There are many websites that can help one to compare among several plans. Now the last question is to ascertain his exposure. One cannot be sure that once a plan is made every thing will go according to it. Say in the above example there is a hike in inflation, there will be high spendings and relatively low increase in incomes. The solution than would be to think wisely as say : Income = House Hold Cost + Savings + Endowments If house hold costs increased then there will be less money to save and to pay towards future or present endowments. Thus here we introduce a policy of breaking your planning sessions. I would suggest to Annie and Mike that make a plan to purchase a house between 5 7 years. Thus if there is any fluctuations that causes disruption we may change our action plan. As if Inflation rises so will the company profits and thus stock returns will go high. And to draw the money from the economy government will issue high rates bonds. We can then use such issue to our advantage. Thus our exposure can be planned if we follow this mantra PLAN EARLY BUT ADJUST IN SESSIONS.

Akash Kapoor B Law, CA(INTER), CPFP, CME