This article was posted on Wednesday, Apr 01, 2015

Mortgages and Trust Deeds (hereafter-“mortgages”) are negotiable instruments. Once created, they act among institutional investors as sort of a bond substitute. They are created for income, bought for security and sold for capital gains. We’ll discuss ordinary income from mortgages and the potential for capital gains another time. Today we’ll focus on the security of mortgages from the lender’s point of view.

There is a huge market for mortgages and other debt instruments among insurance companies, pension funds, and endowments partially because the contract provides for a portion of the principal to be retired with each payment, so the risk-adjusted returns are slightly higher than competing investments. When you buy a lot of debt instruments, as institutional investment managers do, even tiny improvements make a difference.

Other reasons mortgages have favorable investment profiles are (a) the Law of Large Numbers, (b) liquidity, (c) down payment, (d) interest rate adjustments, and (e) the effects of loan amortization and inflation. Over time, these elements transition a credit based loan into an equity based debt instrument. 

Law of Large Numbers

“OK, Phred, I’ve put 100 balls into the bag. They are sequentially numbered from 1 to 100. Just stick your hand in there and see what you get.” Phred pulls out a ball. “Whadya get?”  “It says 100”. “Do it again”. “87”.

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The average of all the balls is 50. As Phred continues to pick numbers out of the bag the average of those drawn will approach the mean of the entire population of balls. Eventually, after he’s drawn all 100 balls, the average number of all the balls will be . . . 50. This is an example of the Law of Large Numbers: the more samples you have, the more their mean will approach the mean of the whole.

Insurance and mortgages work employ the same principle. An insurance company does not know exactly which policies it must pay off in any given year, but if there are enough policies in force the company would have a really good grasp on the total expected losses in any given year. This permits the company to price their insurance accordingly. The more policies they have in force the more confident they can be about their anticipated losses and the more accurate their pricing. It’s just one application of the Law of Large Numbers.

On the other hand, we could buy a single mortgage but we probably would not know how to judge its price. Hypothetically, what is the appropriate risk discount when you know that there has historically been only one foreclosure annually per 500 mortgages, but you don’t know if it’s going to be the one and only loan you bought for your retirement income? However, if you had a lot of loans you could look at the historical data and predict that 0.2% will fail. With that data you could make a more supportable investment decision.  


The Law of Large Numbers relates directly to liquidity. If loans were not able to be bought and sold on the secondary market (secondary market: where existing loans are bought and sold), few institutions would offer them. The risk premium for making the first couple thousand loans would be prohibitive. No primary lender (primary market: where new loansare originated) would relish the risk exposure that comes with making only a small number of loans.

A liquid secondary market means that the hopeful young manager of a new pension fund may buy tens of thousands of existing loans before lunch. He would have enough exposure to be reasonably confident that his maximum likely loss would not exceed the market average. 

Down Payment

They tell you that the three important “C’s” required to qualify for a loan are (1) Character (meaning your credit profile), (2) Capacity (can the building demonstrate enough income to make the loan payments? Can you prove yourself solvent?) and Collateral (if you don’t pay, what can we take?).     

Each of these hurdles has a bunch of sub-requirements. A portion of Character is your ability to make a satisfactory down payment. That would show that historically you live beneath your means. It shows that you can postpone gratification for a greater good.

Although there are some government programs for some properties that require little or no down payment. These are normally government insured or government guaranteed programs. Most upscale SFR’s and income properties, however, require a down payment.

The down payment impacts Collateral in interesting ways. It is the bank’s insurance against “first loss”. If you buy a $100,000 property and put 35% down, you have to lose the entire $35,000 before the bank is out a dime. This protects them from most normal market fluctuations. The larger the down payment, meaning the greater first loss you’re able to take, the less risk there is to the bank and the easier it is to qualify for the loan. 

Interest Adjustments

Most income property loans begin with a fixed rate period for, commonly, 5 or 7 years (and sometimes longer) before switching to an adjustable rate for the balance of the term. This tends to work well for both borrower and lender, although not perfectly for either. The lender manages to transfer inflation risk (this is huge in mortgages and long term bonds) to the borrower. While this is a major benefit to the lender, the borrower protects himself by (a) understanding what the ceiling interest rate is for that particular loan (look for the Letter of Interest your loan broker received from the lender and gave you for your files) and (b) forecasting whether or not the building’s income could reasonably service the loan at the higher rate at the earliest date that might happen.

What’s the ceiling on our new loan, Eunice?” “9.5%. But I’m not worried. It won’t get there for at least six years”. “What happens during that time?” “I’ll be raising the rents every year. It’ll be ok, Phred.” 

Amortization and Inflation

Lenders do a fine job of analyzing mortgage risk at the time the loan is applied for. After all, they have a credit worthy borrower with an ability to service the debt on a building of known value. It’s in the out-years where things get questionable: what happens 10 or 12 years down the road? Will the borrower still be credit-worthy? Will the property still be able to make the payments? What if values have collapsed?

There is no certain answer to these questions, so at first glance it might look like making a long term loan is a fool’s game. Actually, from the lender’s perspective, the further out on the loan curve the more secure the loan becomes. Two things synergize to make this happen. First, a tiny bit of principal is paid back with each mortgage installment. Those principal payments add up over time. After 11 years the principal has been reduced (for example) by 20%. If the borrower originally put 35% down (giving him, at time of purchase, 35% equity in the property), after 11 years he has paid down 20% of the loan. Twenty percent of a $65,000 loan is $13,000. The purchase price was $100,000, so minus the down payment and minus the accumulated pay-down the remaining loan balance is $52,000. The borrower has 48% equity ($100,000 minus $52,000) before considering inflation. The borrower may feel good about that, but the lender feels better.

One expects the building to appreciate at least as much as inflation. Since 1914 inflation has averaged 3.38% annually.  So over 11 years a building would reasonably appreciate 44% due solely to inflation.

These line items work together. After adjusting for equity build-up and inflation, at the end of year 11, the lender has 20% less exposure in a building that has appreciated 44%. Let’s put some numbers to that: 

Year                Value              Owner Equity

Now                $100,000              35%

11                    $144,000              64% 

Credit vs. Equity Based

When the loan is first originated it is primarily credit based. Over time, however, the credit overlay tends to fade away and the mortgage transitions into something more like an equity based loan. It is the combination of equity build-up and inflation that are the lender’s protection during the out-years. 


A lender’s initial security in the loan business revolves around the Law of Large Numbers and an active secondary market. The institution has to own enough mortgages that the portfolio’s default rate will not materially exceed the average of all similar mortgages. An active secondary market requires that each individual loan meets certain hurdles: a solvent borrower; a building that generates enough income to service its debt, and an equity investment by the borrower that minimizes the lender’s risk of first loss.

Over time, the lender’s security (this could be the original lender or a subsequent institution that bought the mortgage) becomes asset based. At a very fundamental level, the lender’s security increases as the borrower’s wealth grows, and that’s a good thing. It puts all of us on the same side of the table. 

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. 

Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected] 

If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at