Anyone who makes an unconditional financial payment commitment extending over many years and wants to live without anxiety about it, maintains a reserve for unexpected contingencies. Mortgage underwriting rules recognize this by requiring loan applicants to have financial assets equal to 2-12 months of monthly payments at time of closing. But after closing, borrowers are stuck with an instrument that prohibits the accumulation of a reserve within the mortgage. The borrower who pays off most of the loan balance with her lottery winnings has the same required payment the next month. The distinguishing feature of the proposed mortgage is that a reserve account under the control of the borrower provides payment flexibility. So long as the actual balance is below the maximum balance, the payment can be anything the borrower wants.
Of course, a borrower with an existing mortgage who has excess funds can always create a reserve account in a bank that can serve the same purpose. The difference is that a reserve account within the mortgage earns the mortgage rate rather than the bank deposit rate. Further, unlike a bank deposit which can be drawn and spent in a weak moment, a mortgage-based reserve cannot be used for any purpose other than making mortgage payments.
The Alternative Mortgage and Home Equity Growth
There are three reasons why balances on the proposed mortgage will be paid down faster. First, defaults would be smaller because of the greater inducement to accumulate reserves. Second, unused reserves will automatically result in early payoff. Third and perhaps most important, the alternative mortgage will dislodge "payment myopia", which is my shorthand term for the widespread practice of basing financial decisions solely on the affordability of monthly payments, without considering how the decisions will affect wealth.
Consumers who are payment myopic all their lives seldom retire with significant wealth. The financial system offers them numerous opportunities for short-term gratification at the expense of the future.
The alternative mortgage discussed here confronts payment myopia head-on by forcing the borrower to focus on the loan balance -- not only this month but every month. Interactive servicing that prompts borrowers to confront the future consequences of actions (and inactions) taken today would play a major role.
About The Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
(c)2017 Jack Guttentag
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