Lesson 23 of 25 · 6 min

Interest as a claim on headroom

Eleven thousand dollars of interest removes sixteen thousand dollars of headroom, because the test is a ratio.

March's $11,343.47 does not only enlarge the balance. It enlarges the trigger. The sample tests loan-to-value against market value at a 70 percent threshold. Trigger value is balance ÷ 0.70. Opening trigger $1,847,220.00 ÷ 0.70 = $2,638,885.71. Closing trigger $1,858,563.47 ÷ 0.70 = $2,655,090.67. The trigger rose $16,204.96. Market value is unchanged at $6,032,795, so every dollar of that rise is headroom gone.

The $16,204.96 is not a second charge. It is $11,343.47 ÷ 0.70. Each dollar of capitalised interest claims 1 ÷ 0.70 = $1.4286 of headroom, because the test is a ratio and the numerator moved. Opening headroom is $3,393,909.29. Closing headroom is $3,377,704.33. Subtract and you recover $16,204.96. The interest line and the headroom line are the same movement read through the threshold.

This is a different multiple from the forced-sale multiple. The forced-sale multiple is 1 ÷ (1 − 0.70) = 3.333…, and it answers a different question: how much collateral has to be sold to restore a ratio once it has broken. The 1.4286 figure answers how much headroom a dollar of interest consumes while the ratio still holds. Mixing the two multiplies the interest by the wrong constant.

April's illustrated $11,182.36 will consume $11,182.36 ÷ 0.70 = $15,974.80 of headroom if market value is still $6,032,795. The year chain's $131,610.03 would consume $188,014.33 on that frozen market, which is $131,610.03 ÷ 0.70. Prices will not sit still for a year. The arithmetic of the claim does not depend on their sitting still. It depends on the threshold remaining 70 percent and the interest remaining inside the numerator.

Key terms

Headroom claim: Interest divided by the threshold. $11,343.47 ÷ 0.70 = $16,204.96 on the sample March.
Trigger value: Balance ÷ threshold. The market value at which loan-to-value equals 70 percent.
Forced-sale multiple: 1 ÷ (1 − threshold) = 3.333… at 70 percent. A different constant, used when a shortfall is being cured by selling collateral.

Worked example

The same $11,343.47, read through 0.70

Sample March. Market value held at $6,032,795. Threshold 70 percent of market value.

Interest capitalised: $11,343.47
Opening trigger: $2,638,885.71
Closing trigger: $2,655,090.67
Trigger rise / headroom consumed: $16,204.96
Opening headroom: $3,393,909.29
Closing headroom: $3,377,704.33

The interest line and the headroom movement are one number and that number divided by 0.70. No price moved in this calculation.

Check yourself

April charges $11,182.36, capitalised, threshold 70 percent, market value unchanged. How much headroom does that charge consume, and what constant is not the right one?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.