The standard U.S. mortgage has two major weaknesses.
First, because the payment obligation is rigid, it is very difficult to manage the repayment process efficiently. Second, because the loan balance that the borrower pledges to repay is not affected by any changes that occur in the economy, the borrower is forced to assume a risk that his or her equity in the property will decline.
The first problem is discussed below; the second will be considered in a future article.
One thing I have learned from many years of answering questions from consumers is that often they try to manage their mortgage in one way or another, often without success.
The existing instrument was not designed to be managed. One that could be effectively managed would result in more rapid pay-down of loan balances and fewer defaults.
Following are some of the standard mortgage's problems:
The borrower's payment obligation is rigid. This is the feature that causes perhaps the most trouble. Currently, a mortgage does not allow a borrower to skip any part of a payment under any circumstances. A borrower who skips a payment but pays regularly thereafter stays delinquent - and accumulates late fees - until the skipped payment is made good.
Making advance payments to avoid future delinquency is costly. If a payment is used to reduce the mortgage balance, the borrower saves on interest, but the future payment obligation is unchanged.
The borrower who wants to use the cash for future payments must make those payments in advance, losing the interest savings. There is no way to do both.
Required payments are not affected by extra payments on a fixed-rate mortgage. The borrower who wants to use a cash windfall to reduce his monthly payment can't do it except by inducing the lender to recast the loan contract - at a price.
On an adjustable-rate mortgage, the payment will decline automatically at the next rate-adjustment date, but that could be years away.
Limited lender feedback discourages extra payments to reduce the balance: Typically, the borrower who makes an extra payment has to wait for the next financial statement before seeing any evidence that his or her balance is lower.
A flexible-payment mortgage would base the borrower's contractual 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" that he could draw on by paying less later on.
The loan is for $160,000 at 5.5 percent for 15 years, with a monthly payment of $1,307.34. 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 five 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 eight 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 $1,307.34 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.
The flexible mortgage requires simulation capacity for maximum effectiveness. For borrowers to use it in the most efficient way possible, they need access to their accounts and to a program that allows them to experiment with what-if scenarios of the types illustrated above.
This is not rocket science. The numbers cited above were drawn from an Excel spreadsheet that required only minor add-ons to an existing amortization spreadsheet.
There have been some attempts to create a flexible mortgage, of which the most interesting was a CMG Financial plan I wrote about several years ago. For various reasons, it never took off.
Given the dominant role of Fannie Mae, Freddie Mac, and the Federal Housing Administration in our current system, one or all of those agencies probably has to be involved to make the flexible mortgage widely available.
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. http://www.mtgprofessor.com.