How Would a Truly Flexible Mortgage Work?
6 September 2004, Postscript November 28, 2007
Postscript: When this article was first written in 2004, I was not aware of the Home Ownership Accelerator (HOA) offered by CMG Mortgage. I wrote an article on HOA in 2005, but did not appreciate that it actually met the specifications for a truly flexible mortgage that I had set down the previous year. I made amends recently by rewriting that article, see The CMG Plan: Your Mortgage as a Checking Account. The remained of this article can be viewed as a prelude to that one.
Borrowers need a flexible payment mortgage that would allow them to accumulate a reserve within the mortgage by paying extra when they have extra funds, allowing them to skip or reduce payments when necessary.
Fannie Mae's Payment Power program allows a borrower to skip up to 2 mortgage payments in any 12 month period, and up to 10 over the life of a loan. A skipped payment results in an additional loan, equal to the payment plus a healthy access fee, tacked on to the balance. As an emergency source of funds, it is much more costly than accessing a home equity line of credit (HELOC). See Payment Flexibility Under "Payment Power"
My view is that borrowers don’t need a high-cost way to borrow for emergencies. What they need is a no-cost way to accumulate a reserve within their existing mortgage that would allow them to skip or reduce payments when necessary. A truly flexible mortgage would provide this.
The flexible mortgage would base the borrower’s payment obligation on the loan balance. A schedule of required balances, declining month by month over the life of the loan, would be part of the contract. If the borrower made all the scheduled payments, his balances month by month would correspond exactly to the required balances. But if he paid more in some months, his actual balance would fall below the required balance, the difference constituting a "reserve account" which he could draw on by paying less later on.
For example, the loan is for $160,000 at 5.5% for 15 years, with a monthly payment of $1307.34. 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 $1307.34 to $1,000 starting in year 4, he could do it for 39 months before exhausting his reserve.
The beauty of the flexible mortgage from a borrower’s perspective is that once he gets ahead of the game, his payment can be anything he wishes. The only limitation is that the actual balance must stay below the maximum balance each month.
This flexible mortgage is not rocket science. The numbers cited above were drawn from an Excel spreadsheet that required only a minor add-on to an existing amortization spreadsheet. The payment option adjustable rate mortgage (ARM) that many lenders offer today is far more complicated.
Servicing a flexible mortgage presents only modest challenges. At a minimum, the lender would have to inform the borrower of the minimum payment required each month, something they do now on option ARMs. It would not be difficult to provide a wider range of possibilities, or to allow borrowers to test their own preferences by accessing their account over the internet.
Since the borrower’s obligation on a flexible mortgage is defined in terms of the balance rather than the payment, delinquency and default would also be defined in this way. Delinquency would be a single occurrence where the actual balance exceeded the required balance, and default would be a succession of months (perhaps 3) in which this happened.
The flexible mortgage encourages borrowers to save nuts for the winter. Hence, I would expect that both delinquencies and defaults would be lower than on our current mortgages.
Some lenders in the UK, Australia and South Africa provide mortgages with much greater payment flexibility than anything available in the US. At least one large lender in South Africa allows complete payment flexibility so long as the balance does not exceed the original balance, which is much more radical than using a declining required balance.
Postscript: When this article was first written in 2004, I was not aware of the Home Ownership Accelerator (HOA) offered by CMG Mortgage. I wrote an article on HOA in 2005, but did not appreciate that it actually met the specifications for a truly flexible mortgage that I had set down the previous year. I made amends recently by rewriting that article, see The CMG Plan: Your Mortgage as a Checking Account. The remained of this article can be viewed as a prelude to that one.
Borrowers need a flexible payment mortgage that would allow them to accumulate a reserve within the mortgage by paying extra when they have extra funds, allowing them to skip or reduce payments when necessary.
Fannie Mae's Payment Power Program
Fannie Mae's Payment Power program allows a borrower to skip up to 2 mortgage payments in any 12 month period, and up to 10 over the life of a loan. A skipped payment results in an additional loan, equal to the payment plus a healthy access fee, tacked on to the balance. As an emergency source of funds, it is much more costly than accessing a home equity line of credit (HELOC). See Payment Flexibility Under "Payment Power"
My view is that borrowers don’t need a high-cost way to borrow for emergencies. What they need is a no-cost way to accumulate a reserve within their existing mortgage that would allow them to skip or reduce payments when necessary. A truly flexible mortgage would provide this.
How a Flexible Payment Mortgage Would Work
The flexible mortgage would base the borrower’s payment obligation on the loan balance. A schedule of required balances, declining month by month over the life of the loan, would be part of the contract. If the borrower made all the scheduled payments, his balances month by month would correspond exactly to the required balances. But if he paid more in some months, his actual balance would fall below the required balance, the difference constituting a "reserve account" which he could draw on by paying less later on.
For example, the loan is for $160,000 at 5.5% for 15 years, with a monthly payment of $1307.34. 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 $1307.34 to $1,000 starting in year 4, he could do it for 39 months before exhausting his reserve.
The beauty of the flexible mortgage from a borrower’s perspective is that once he gets ahead of the game, his payment can be anything he wishes. The only limitation is that the actual balance must stay below the maximum balance each month.
This flexible mortgage is not rocket science. The numbers cited above were drawn from an Excel spreadsheet that required only a minor add-on to an existing amortization spreadsheet. The payment option adjustable rate mortgage (ARM) that many lenders offer today is far more complicated.
Servicing
Servicing a flexible mortgage presents only modest challenges. At a minimum, the lender would have to inform the borrower of the minimum payment required each month, something they do now on option ARMs. It would not be difficult to provide a wider range of possibilities, or to allow borrowers to test their own preferences by accessing their account over the internet.
Since the borrower’s obligation on a flexible mortgage is defined in terms of the balance rather than the payment, delinquency and default would also be defined in this way. Delinquency would be a single occurrence where the actual balance exceeded the required balance, and default would be a succession of months (perhaps 3) in which this happened.
The flexible mortgage encourages borrowers to save nuts for the winter. Hence, I would expect that both delinquencies and defaults would be lower than on our current mortgages.
Flexible Payment Mortgages Abroad
Some lenders in the UK, Australia and South Africa provide mortgages with much greater payment flexibility than anything available in the US. At least one large lender in South Africa allows complete payment flexibility so long as the balance does not exceed the original balance, which is much more radical than using a declining required balance.