November 10, 2014

Last week I wrote about the so-called wealth-builder (WB) mortgage, designed to marry the rapid balance pay-down of a 15-year mortgage with the low monthly payment of a 30. I concluded that without the lender or government providing a subsidy, WB doesn’t work.  

That doesn’t mean that our existing mortgages can’t be improved in ways that will stimulate wealth creation. One of the things I have learned from many years of answering questions from consumers is that often they try to manage their mortgage in one way or another, but without much success. The existing instrument was not designed to be managed. An instrument that could be effectively managed would result in more rapid pay-down of loan balances and smaller numbers of defaults.  

Rigidity of the Payment Obligation 

Perhaps the feature that causes the most problems is the absolute rigidity of the payment obligation.  Here is a sample letter: 

"I wasn't able to make my April mortgage payment last year but I have made every payment on time since then.  But my lender sends me late charge notices every month since that happened.  And when I applied recently for a credit card, I was told that I was a high-risk customer because of my mortgage payment delinquencies.  I only skipped one payment, so what is going on? "   

What indeed.  I was obliged to inform this borrower that: 

"Your loan contract does not give you the right to skip a payment.  The payment you skipped made you delinquent, and you have stayed delinquent ever since.  

Lenders credit a payment against the earliest unpaid obligation.  When you made your payment last May, you received credit for April, which meant that your May payment was late.  When you made your payment in June, it was applied to May, leaving the June payment delinquent, and so on.  A borrower who skips a payment but pays regularly thereafter stays delinquent (and accumulates late fees) until the skipped payment is made good…" 

The current mortgage does not allow a borrower to skip any part of a payment under any circumstances.  This is bad for lenders as well as borrowers because a borrower who gets behind and doesn't have the means to catch up may be on a slippery slope to default. 

Of course, budgetary discipline is necessary, but it should be combined with the flexibility needed to adjust to changes in circumstances. The alternative mortgage I will describe next week has both.  

Rigidity of the Payment Period 

All mortgage borrowers are forced to accept the month as their payment period, whether it fits their own budgetary needs and practices or not. Some would do better paying weekly, or every other week, or twice a month, but these options are either not available, or available only at heavy cost to the borrower. 

Inability to Reduce the Payment on a Fixed-rate Mortgage Through Partial Prepayment 

Borrowers are often shocked to learn that they can't reduce the payment on a fixed-rate mortgage (FRM) by prepaying some of the balance. 

"I recently came into an inheritance and want to use the money to reduce my mortgage payment.  My lender tells me, however, that I can't do it.  If I pay down the balance it just shortens the time till final payoff.  Is there any way I can do what I want?" 

My reply: 

"Sad to say, if you have a fixed-rate mortgage, the only way to accomplish your objective is to refinance.  The new loan can be smaller, and the payment will be reduced correspondingly." 

Some lenders are willing to reduce the payment by rewriting the loan contract, but they will charge a fee that could exceed the cost of a refinance. 

Making Advance Payments Is Costly 

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.  Underwriting rules recognize this by requiring borrowers 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 discourages the accumulation of reserves.   

The borrower with excess cash can save interest on the mortgage by paying down the balance, but this leaves the future payment obligation unchanged. The borrower who wants to use the cash for future payments must make these payments in advance, losing the interest saving. There is no way to do both. The standard mortgage does not allow a borrower to store nuts for the winter without losing interest on the nuts. 

Next week: A mortgage that meets these problems without creating new ones.