A Right to Recast
Growth in home equity during
working years is important because home equity is a
potential source of spendable funds after retirement. In a
recent article (Repaying
Your Mortgage Early: Your Method Can Be Better than the
Lender’s) I suggested
that mortgage borrowers might develop an extra payment plan
that would pay off their loan balance before term using
calculator 2a on my web site, which was developed solely for
that purpose.
This article deals with another
dimension of the problem, which is motivation. For many
borrowers, becoming mortgage-free is a long way off, and
benefits deferred so long may not provide enough incentive
to reallocate funds to an extra payment plan. I will propose
a modest adjustment in the standard mortgage contract that
will provide an added incentive for borrowers to develop and
stick to an extra payment plan. The proposal is to provide
all mortgage borrowers with the right to recast their
mortgage. The value of this provision to borrowers would be
many times greater than its cost to lenders.
What Is a Mortgage Recast?
A mortgage recast is a
change in the monthly payment that makes the payment
fully-amortizing. A fully-amortizing payment is one that, if
continued throughout the remaining life of the loan, will
just pay off the balance at term. A recast will be a
payment increase when the existing payment is less than
fully-amortizing, and a payment decrease when the existing
payment is more than fully-amortizing.
For example, the borrower who has
been paying interest only amounting to $500 on a $100,000
30-year mortgage at 6%, after 10 years faces a mandatory
recast increase to a fully amortizing payment of $716. In
contrast, a borrower with the same mortgage who has
voluntarily paid $800 a month for 10 years, faces a possible
recast decrease to $364. The problem has been that recast
increases have been mandated by mortgage contracts while
recast decreases require the lender’s permission.
Payment-Increase Recasts Have
Been Used to Protect the Lender
Payment-increase recasts are designed
to protect the lender by making sure that the loan will pay
off as scheduled. All interest-only loans, and all ARMs that
allow payments that are less than fully amortizing have
explicit provisions for recasts in the loan contract.
Payment-increase recasts occur
on two kinds of mortgages. One carries an interest-only
option, where the required payment for some initial period,
often 10 years, only covers the interest. While many
mortgages with interest-only provisions were written before
the financial crisis, in today’s market, most interest-only
mortgages are HELOCs. The payment-increase recast occurs at
the end of the interest-only period.
The second type of mortgage open to a
payment-increase recast is the adjustable rate mortgage
(ARM) that allows payments that are less than fully
amortizing. Common before the financial crisis, these ARMs
sometimes had recasts at specified intervals, often every 5
years, or the recast may have been triggered by the loan
balance reaching some limiting value, such as 110% of the
original loan amount. Some of these loans are still around
but as far as I know, no new ones are being written.
Payment-Decrease Recasts
Have Not Been Used to Protect the Borrower
To my knowledge, mortgage contracts
have never included provision for payment-decrease recasts.
The occasional borrower who wants one has to request it from
the lender, who can agree to it, can agree subject to a
charge which can range from nominal to extortionate, or can
refuse it.
Most borrowers who request recasts
usually have fixed-rate mortgages on which they have been
making extra payments in order to pay off before term, and
then unexpectedly encounter a financial reversal. With their
income reduced, their objective shifts from paying off early
to reducing the payment, for which purpose they need a
recast. They deserve it, the cost to the lender is nominal,
but some lenders will take advantage of them just because
they can.
Payment-reducing recasts are needed
for fixed-rate mortgages much more than for ARMs. The reason
is that when the interest rate is adjusted on an ARM, the
payment is automatically recast. On ARMs that reset the rate
every year, no additional recasts are needed. On ARMs with
initial rate periods of 5-10 years, however, the need for a
recast can arise in the early years just as it does on FRMs
Why Payment-Reduction Recasts
Ought to Be a Standard Provision
The borrower’s right to a
payment-reducing recast ought to be mandatory for all home
mortgage contracts. Borrowers should not have to grovel for
what can be critically important to them and of little
consequence to lenders. Making recasts into a right would
have the side benefit of encouraging borrowers to make extra
payments as a form of contingency insurance.
Today, borrowers are motivated to make extra payments primarily by the hope of getting out of debt sooner. With a right of recast made explicit, they will also view extra payments as a worst case backstop. The more you pay when you have the means, the larger the payment reduction you can command in an emergency. I can’t think of an easier way to motivate consumers to save more.
