“What do you
think of the new Wealth-Builder mortgage that has gotten a
lot of press?”
The developers of the Wealth-Builder (WB), Edward Pinto and
Stephen Oliner of the American Enterprise Institute view the
30-year mortgage that today dominates the market as badly
flawed. Their view is that it
takes too long to accumulate significant wealth, and too
many bad things can happen in the meantime that jeopardize
that goal. The WB would have a term of only 15 years.
Here are some figures that illustrate their point. On
October 23, I shopped the market as a potential home buyer
with a 740 credit score who could make a 20% down payment on
a $250,000 single-family house. The $200,000 loan I needed
was available for 30 years at 3.75%, or for 15years at
2.875%. If I took
the 30-year loan, after 8 years of making payments, my
balance would be down by $33,663, or by only 17%; if I took
the 15, my balance would be down by $99,936 or by 48% --
almost 3 times as much wealth accumulation.
The much larger pay-down on the 15 reflects both the lower
rate, and the larger payment: $1369 as compare d to $926 on
the 30. It is this lower payment on the 30 that attracts
borrowers to it.
The objective of those developing the WB is to combine the
more rapid wealth accumulation of the 15 with a payment that
is “almost as low” as that of the 30. The only way to reduce
the payment on a 15-year mortgage without reducing the loan
amount is by reducing the interest rate. This raises two
questions. How large a rate reduction would be needed, and
where would it come from?
On the first question, I have scoured all the documents on
WB I could find, and none mentioned the reduction in
interest rate required to make the payment “almost as low”
as that on a 30. I decided, therefore, to check it out
myself.
The payment of $1369 on the 15 in my example was 47.8%
higher than the payment of $926 on the 30. Let’s assume that
a payment on the 15 that is “almost as low” as the payment
on a 30 is 10% higher, or $1019. But this payment would
require an interest rate of minus 1.13%, which is not
possible. If we
raise the target payment on the 15 to 20% above the payment
on a 30, or to $1,111, the required rate on the 15 is zero,
and that is not possible either. Conclusion: There is no
possible way to reduce the payment on the 15 to anything
close to the payment on a 30 through a reduction in the
interest rate.
Let’s go to question 2: where would any rate reduction come
from? The source is a cash payment by the borrower to the
lender of money that would otherwise have been used as the
down payment. Instead
of down payment, it is paid as points that “buy down” the
interest rate. This has the unfortunate effect of reducing
the borrower’s equity in the house at the outset, so he
begins with less equity using the WB than if he took the 30.
This is not a good beginning for a program designed to
accelerate wealth accumulation.
The other consequence of converting down payment into points
that buy down the interest rate is increased default risk to
the lender. We know that smaller down payments result in
more defaults. The developers of WB would deal with this by
changing underwriting rules in ways that would reduce risk,
offsetting the effect of lower down payments. They propose
to replace the current limits on debt-to-income ratios with
evaluations of the borrower’s entire budget.
While this would
indeed be a step forward, down payment requirements and
debt-to-income requirements deal with two different aspects
of risk, and strengthening the second cannot fully offset a
weakening of the first. Furthermore, the problem of stupid
underwriting rules applies to the entire market; fixing the
rules only for the WB makes no sense.
Of course, lenders could reduce the interest rate at their
own expense, in effect subsidizing the transaction, or
Governments could pay the points required to buy down the
rate. But then WB becomes a subsidy program, and it should
be evaluated as such and compared to alternative subsidy
programs.
I hasten to add that I believe the current mortgage design
is in many respects obsolete and badly needs an upgrade.
But the WB is not
it. I will be writing about more promising models in the
weeks to come.
