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6 September 2004
Payment Flexibility Under
"Payment Power" describes Fannie Mae's Payment Power program. It 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).
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. Here is how it 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 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.
On some automobile loans in the US, a
borrower who makes a double payment one month can skip paying the next month. If
the borrower makes a triple payment, he can skip two months, and so on. This is
not nearly as flexible as the declining balance proposal, but it is very simple
and would be a step forward.
Copyright Jack Guttentag 2004
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