The Retirement Funds Crisis arises out of increasing life expectancy, and the shift from defined benefit pension plans provided by employers to defined contribution plans funded mainly by retirees.
The home mortgage affects the crisis, one way or the other. At worst, the home mortgage is carried into retirement, with the required monthly payment constituting an additional drain from the retiree’s pocket. At best, the mortgage has long since been repaid, clearing the decks for a possible reverse mortgage that will put money back into her pocket.
This article and the several that follow describe a number of policy changes that will encourage faster loan balance pay-downs, without reducing affordability.
Equity-Growth and Affordability
Since the 1930s, public policy has focused on the affordability of mortgages rather than the rapidity of repayment. This affordability bias reached its peak in the years leading up to the financial crisis, which saw the emergence of interest-only provisions tacked onto the first 5 or 10 years of 30-year mortgages — which meant that for 5 or 10 years there was no pay down in the loan balance at all. Option ARMs went even further, allowing borrowers to make payments that didn’t fully cover the interest, which resulted in an increase in the loan balance – called “negative amortization”.
These instruments are gone and good riddance, but affordability continues to be an important policy objective. Hence, the new objective should be to find ways to accelerate equity growth that do not impair affordability. Given that restriction, the most direct approach to faster equity growth, shortening the maximum allowable term, is off the table.
Eliminating the Rigid Monthly Payment Requirement
The fixed monthly payment required on all home mortgages is a design for robots that leaves no scope for discretion. In particular, there is no way for the borrower to accumulate reserves in order to skip some future payments. The borrower who wins the lottery and pays off half the balance must make the same payment on the next due date.
The requirement of a fixed monthly payment could be replaced by a schedule of required balances, declining month by month over the life of the loan. The initial required payment would be fully amortizing, calculated in the same way as it is now, but beginning in month 2 the required payment would be whatever amount is needed to meet the maximum balance in that month. If the borrower pays more than the fully amortizing payment in some months, he would be able to pay less in subsequent months while meeting the balances required in those months.
Going from a minimum required payment to a maximum required loan balance allows borrowers to accumulate a reserve within the mortgage, which provides payment flexibility. The larger the reserve from making payments in excess of the initial fully-amortizing payment, the longer the borrower can go with reduced payments or none at all.
Importance of Reserve Accounts
There are two reasons why balances on the proposed mortgage will be paid down faster. The first is that the practices that a borrower adopts to generate a reserve will serve as well to pay off the balance early. For example, the borrower who uses a periodic bonus to increase her reserve is very likely to continue with the practice until the loan is fully repaid. .
In addition, the required balance mortgage will dislodge “payment myopia”, which is the widespread practice of basing financial decisions solely on the affordability of monthly payments, without considering how the decisions will affect wealth. Consumers who are payment myopic seldom retire with significant wealth. The required balance mortgage forces the borrower to focus on wealth.
A Right to Recast the Payment Will Further Encourage Creation of Reserve Accounts
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. Providing all mortgage borrowers with the right to recast their mortgage will provide an added incentive for borrowers to develop and stick to an extra payment plan. The cost to lenders would be minimal.
A mortgage recastis a change in the monthly payment that makes the payment fully-amortizing. On existing mortgages, recasts are mandated when the payment is less than fully amortizing (as on a loan with an interest-only provision) but they are not allowed when the payment is more than fully amortizing without the lender’s permission. Allowing recasts at the borrower’s discretion when the borrower has accumulated a reserve would encourage them to make the extra payments that generate the reserve.
Adapting Loan Servicing Systems
To realize the full potential of the required balance mortgage, servicing systems must become interactive. A borrower at any time should be able to “try out“ alternative payment schemes and immediately see the implications for future loan balances and required payments.
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