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The Mortgage Professor: Revising the standard mortgage to meet today's challenge

Jack Guttentag, The Mortgage Professor on

Published in Home and Consumer News

People are living longer, which means they need more wealth when they stop working. If they are homeowners, one approach to this objective is to find ways to encourage them to pay off their mortgages in full before they retire. In this way, their full home equity becomes available for conversion into spendable funds if needed.

The existing standard mortgage was not designed to encourage repayment of the loan balance. Rather, since the 1930s the public policy objective has been to promote home ownership by making mortgages more affordable. The focus has been on strategies for making the monthly mortgage payment as low as possible, with repayment of the balance left to take care of itself.

This article describes an alternative mortgage design that allows borrowers to manage their loans in ways that are not possible with the existing mortgage. This provides stronger inducements to repay the loan balance.

The Alternative Design

The initial required payment would be fully amortizing, calculated in the same way as it is now on most existing fixed-rate mortgages. But where future required payments on existing mortgages don't change, future required payments on the alternative are based on the loan balance. A schedule of required balances, declining month by month over the life of the loan, would be part of the loan contract. If the borrower pays more than the fully amortizing payment in some months, he would be able to pay less in subsequent months while meeting the balances required in those months.

Going from a minimum required payment to a maximum required loan balance allows borrowers to accumulate a reserve within the mortgage, which provides payment flexibility. Here is an example: The loan is for $160,000 at 5.5 percent for 15 years, with a monthly payment of $1,307.34. The borrower receives a bonus every Christmas from which he pays an extra $1,000 on his mortgage. With each extra payment, the gap between his actual balance and the required balance widens. If he does this 5 years running and then loses his job, he can skip his payment entirely in months 72, 73, 74, and 75, and in month 76 he can pay only $575. At that point, the actual balance and required balance are equal, so his reserve is exhausted.

 

Or suppose the borrower inherits $10,000, which he decides to use as an extra payment in month 12. If he falls sick in month 37, he can skip 8 payments and most of a ninth before his reserve is exhausted.

In many cases, a borrower wants only to reduce the payment, as opposed to skipping it entirely. If the borrower who prepaid $10,000 in month 12 needed to cut his payment from $1,307.34 to $1,000 starting in year 4, he could do it for 39 months before exhausting his reserve.

To realize the full potential of the flexible mortgage, servicing must allow borrowers to make the kinds of calculations shown above. Loan servicing must be interactive so that at any time a borrower can "try out " alternative payment schemes and immediately see the implications for future loan balances and required payments.

Importance of Reserve Accounts

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