Tina: Yes, let me give you an example: Mike bought a house two years ago. The house was worth $160,000 when he purchased it. He paid $10,000 as down payment, and he got a loan from ABC bank for $150,000. The house is collateral.
Tom: What kind of interest does he have to pay?
Tina: For a 30 year loan, the average interest rate was 5% at that time.
Tom: When you say “the house is collateral,” does it mean that before Mike pays off the loan, the bank actually owns the house?
Tina: Exactly. The bank owns the house because it owns the “mortgage paper.”
Tom: So, mortgage paper itself is an asset?
Tina: That’s right. Now if Mike defaults his loan, the bank can legally take back the house.
Tom: You mean if Mike lost his job, he can no longer make his monthly payment to his bank?
Tina: Yes. Let’s say, a year later, Mike was to get laid off. He would no longer have monthly income to pay for his mortgage. Also, the value of the house was greatly reduced from $160,000 to $100,000 because of housing market crash. Mike would still owe the bank almost $150,000.
Tom: How come? Wasn’t he paying for his mortgage during that year?
Tina: Well, for a 30 year mortgage, the monthly payments for the first few years are mainly applied towards the interest and very little goes to the principle.
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