Mortgage duration is a term that is used in two specific ways. One application of the term has to do with how long a mortgage is active from the granting of the loan until it is scheduled to be paid in full. A second use of mortgage duration is connected with the impact that early payment of mortgages has on the value of a mortgage-backed security. With both applications, the idea is to track the benefits or liabilities of retiring a mortgage early.
Debtors typically think of mortgage duration in terms of how many more monthly installment payments remain on a mortgage obligation. This is especially true if the debtor is thinking of attempting to make extra payments as a means of retiring the obligation sooner than expected. In the event that the mortgage contract does not include provisions that allow penalties for early settlement, this strategy can generate significant savings in interest rate charges, even if the debt is retired no more than two to five years early.
Many lenders are able to provide mortgage holders with what is known as a payoff amount. This amount allows for the assessing the remainder of the mortgage duration associated with a given loan mortgage, and calculating how much the debtor must pay by a specific date in order to retire the debt and avoid paying the same amount of interest charges that would accrue if the loan were paid according to terms. For example, if the debtor has another ten years to go on a 30-year mortgage but wants to settle the account in full now, the lender would specify the amount it would take to pay off the mortgage, after allowing for the deduction of the interest that would be paid over that ten year period.
Investors who deal in mortgage-backed securities are also concerned with mortgage duration. This is because the duration of the mortgages used to back a given security play a role in determining the price movement of that security, including some influence on the shift of interest rates that apply to the security. For this reason, investors monitor prepayment speed closely as well as consider the fluctuation on interest rates, assessing the degree of influence on those changes, and determining if holding or selling the mortgage-backed security is the most prudent move at any given point in time.
Another reason that investors watch mortgage duration so closely is that the longer that the underlying mortgages remain open, there is a greater risk of fluctuation of applicable interest rates. This in turn affects the return that the investor earns. For example, a longer mortgage duration may result in an increase in the value of the mortgage-backed security if interest rates are rising. Should the interest rates decline, this in turn will have a negative impact on the value of the security, which in turn decreases the potential of investors earning a desirable return.