Last week I suggested that the standard mortgage was difficult for many borrowers to manage because of its rigid payment obligation, the fixed payment period and payment amount, and the high cost of building a payment reserve. This article introduces what I will call the manageable mortgage which has none of these problems. It would give borrowers the leeway to integrate the management of their mortgage into their lifestyle and budgetary practices, without weakening the discipline that many borrowers require.
HOW MANAGEABLE MORTGAGE WOULD WORK
•Interest and payments:
Interest would accrue daily instead of monthly, so borrowers have an incentive to pay early rather than late. Payments would reduce principal by the same amount on the day received. There is nothing novel about this; HELOCs and simple interest loans work this way now.
Payments could be made on any day for any amount. Since interest accrues daily, there is no need to partition payments into interest and principal components. Payments go entirely to principal.
•The borrower’s obligation:
The discipline imposed on the borrower is defined in terms of the loan balance rather than the payment. On any given day there is a maximum balance which declines day by day over the term of the loan. The maximum balance schedule is shown in the note.
So long as the loan balance is below the maximum balance, the borrower is OK. It doesn’t matter how the balance was reduced to its current level. It is up to the borrower to determine when payments are made and how large they are.
The technique of defining the borrower’s obligation in terms of the balance rather than the payment has also been used before, notably by CMG, which created such a mortgage before to the financial crisis.
A borrower is in violation when the actual balance is greater than the maximum balance. (Call this “excess balance”). An excess balance up to some amount stipulated in the note might be allowable, the equivalent of the current 15-day grace period.No late charges need be imposed, however, because interest would continue to accrue.
To minimize disruption to existing systems, a delinquency could be defined as an excess balance exceeding 30 days, while a default would be an excess exceeding 90 days.
The schedule of maximum balances could be defined as the balances in an amortization schedule based on fully-amortizing monthly payments. It also could be hand-tailored to the payment preferences of the borrower.
However the schedule of maximum balances is defined, borrowers would be provided with amortization schedules based on their own payment preferences. If they wanted to pay biweekly, for example, they would receive a biweekly payment amortization schedule.
•Use of the Internet:
In addition, borrowers would have access to their loan files on the internet. On the day they log in, they would see their current balance, maximum balance, and the number of days until their balance equals their maximum balance
Borrowers would also be offered easy simulation capacity so they can play “what ifs” with regard to future payments. They would be able to specify future payments in a variety of ways, and in each case trace the effect on the balance versus the maximum balance. In this way, the manageable mortgage could become the core of the intelligent household’s financial planning.
ELIMINATING RIGIDITIES OF THE STANDARD MORTGAGE
The Manageable Mortgage would eliminate the rigidities of the standard mortgage.
•Payments could be skipped or deferred:
Borrowers cannot skip a payment on the standard mortgage under any circumstances. On the manageable mortgage, in contrast, borrowers could skip a payment so long as their balance stays below the maximum. Those with fluctuating income could adopt a payment schedule at the outset that is a little larger than needed for full amortization, building in the capacity to skip one or more payments. Alternatively, they can build up the capacity to skip payments by making extra payments earlier.
•Borrowers can select their own payment period:
The standard mortgage requires borrowers to pay monthly. On the manageable mortgage, in contrast, borrowers could elect to make payments monthly, weekly, every other week, twice a month or something else – whatever best suits their income pattern and budget practices.
•Borrowers can reduce the monthly payment by making extra payments to principal:
On the standard fixed-rate mortgage, borrowers cannot reduce their monthly payment by making extra payment to principal. On the manageable mortgage, in contrast, there is no required payment, so the borrower who reduces the balance by making extra payments can reduce the periodic payment without breaching the maximum balance rule.
•Borrowers can accumulate a payment reserve without loss of interest:
With a standard mortgage, a borrower with excess cash can either make payments early, losing the interest saving, or pay down the balance to save the interest, but not both. On the manageable mortgage, the borrower can do both because an extra payment saves interest at the mortgage rate, and also allows a reduction in future payments.
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.