What Is a Paydown?
Bonds: refunding by a company of an outstanding bond issue through a smaller new bond issue, usually to cut interest costs. For instance, a company that issued $100 million of 12% bonds a few years ago will pay down (refund) that debt with a new $80 million issue with an 8% yield. The amount of the net deduction is called the paydown.
Mortgage securities are similar to bonds and are investments in a group of mortgages. The paydown feature is typically seen with mortgage-backed securities.
As an example of mortgage-backed securities issuance, assume that an issuer has collected 1,000 mortgages, each worth $100,000 with a 30-year maturity and a fixed interest rate of 6.50%. This $100 million pool of mortgages can be used to back 10,000 bonds, each worth $10,000 with a 30-year term and a fixed coupon rate of 6.00%. Each bond shares the same coupon rate and other features, and importantly, each has a similar claim on all payments. The MBSs are structured so that interest payments on the mortgages are at least sufficient to cover the interest payments due on the bonds (plus the fees of the intermediaries). Principal payments (either scheduled payments or prepayments) on the mortgages are used to pay down the principal on the bonds.
The MBSs exhibit a variety of structures. The most basic types are pass-through participation certificates, which entitle the holder to a pro-rata share of all principal and interest payments made on the pool of loan assets. More complicated MBSs, known as collaterized mortgage obligations or mortgage derivatives, may be designed to protect investors from or expose investors to various types of risk. An important risk with regard to residential mortgages involves prepayments, typically because homeowners refinance when interest rates fall. Absent protection, such prepayments would return principal to investors precisely when their options for reinvesting those funds may be relatively unattractive.
Government or related agencies often issue mortgage securities and people are reimbursed for their investments as the individuals owning the mortgages pay off their loans. Some of the agencies that issue mortgage securities also must provide monthly reports to security owners, which may include something called a paydown factor. A paydown factor is an accounting of the money received by mortgage holders which lists the principal amounts still owed on loans. Any payments to principal undergo a complex formula, which then demonstrates how much money is still owed. When the market is good and mortgage holders are regularly making their payments, this “factor” should show a decreasing amount of money owed monthly, though issuing new mortgages might change this.
Each month a mortgage holder makes payments, the loan is recalculated. Total amount owed may change, unless the mortgage holder is only making interest payments, and in ideal circumstances, each monthly payment pays down part of the mortgage. Borrowers looking at monthly mortgage statements should see a descending balance. Many financial advisers recommend that the balance will decrease faster if people tighten their belts, when at all possible, and increase paydown amount. Instead of simply sticking to the minimum payment, making greater payments to the principal of the loan can be of considerable use in ending a payment obligation sooner. People will also pay less interest overall.
This could be especially important if the loan is upside down, which means the loan amount is higher than the assessed level of the house. Budgeting a larger paydown each month could eventually mean holding equity in the home, instead of simply holding a loan that would not be repaid with the home’s sale.