Growth in home equity during working years is important because home equity is a potential source of spendable funds after retirement. In a recent column (Repaying your mortgage early), I suggested that mortgage borrowers might develop an extra payment plan that would pay off their loan balance before term using calculator 2a on my website, which was developed solely for that purpose.
This article deals with another dimension of the problem, which is motivation.
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. I propose a modest adjustment in the standard mortgage contract that will provide an added incentive for borrowers to develop and stick to an extra payment plan.
The proposal is to provide all mortgage borrowers with the right to recast their mortgage. The value of this provision to borrowers would be many times greater than its cost to lenders.
A mortgage recast is a change in the monthly payment that makes the payment fully amortizing. A fully-amortizing payment is one that, if continued throughout the remaining life of the loan, will just pay off the balance at term. A recast will be a payment increase when the existing payment is less than fully amortizing, and a payment decrease when the existing payment is more than fully amortizing.
For example, the borrower who has been paying interest only amounting to $500 on a $100,000 30-year mortgage at 6 percent, after 10 years faces a mandatory recast increase to a fully amortizing payment of $716. In contrast, a borrower with the same mortgage who has voluntarily paid $800 a month for 10 years, faces a possible recast decrease to $364. The problem has been that recast increases have been mandated by mortgage contracts while recast decreases require the lender's permission.
Payment-increase recasts are designed to protect the lender by making sure the loan will pay off as scheduled. All interest-only loans, and all ARMs that allow payments that are less than fully amortizing, have explicit provisions for recasts in the loan contract.
Payment-increase recasts occur on two kinds of mortgages. One carries an interest-only option, where the required payment for some initial period, often 10 years, only covers the interest. While many mortgages with interest-only provisions were written before the financial crisis, in today's market, most interest-only mortgages are HELOCs. The payment-increase recast occurs at the end of the interest-only period.
The second type of mortgage open to a payment-increase recast is the adjustable rate mortgage (ARM) that allows payments that are less than fully amortizing. Common before the financial crisis, these ARMs sometimes had recasts at specified intervals, often every five years, or the recast may have been triggered by the loan balance reaching some limiting value, such as 110 percent of the original loan amount. Some of these loans are still around but as far as I know, no new ones are being written.
To my knowledge, mortgage contracts have never included provision for payment-decrease recasts. The occasional borrower who wants one has to request it from the lender, who can agree to it, can agree subject to a charge that can range from nominal to extortionate, or can refuse it.
Most borrowers who request recasts usually have fixed-rate mortgages on which they have been making extra payments in order to pay off before term, and then unexpectedly encounter a financial reversal. With their income reduced, their objective shifts from paying off early to reducing the payment, for which purpose they need a recast. They deserve it, the cost to the lender is nominal, but some lenders will take advantage of them just because they can.
Payment-reducing recasts are needed for fixed-rate mortgages much more than for ARMs. The reason is that when the interest rate is adjusted on an ARM, the payment is automatically recast. On ARMs that reset the rate every year, no additional recasts are needed. On ARMs with initial rate periods of five to 10 years, however, the need for a recast can arise in the early years just as it does on FRMs
The borrower's right to a payment-reducing recast ought to be mandatory for all home mortgage contracts. Borrowers should not have to grovel for what can be critically important to them and of little consequence to lenders.
Making recasts into a right would have the side benefit of encouraging borrowers to make extra payments as a form of contingency insurance.
Today, borrowers are motivated to make extra payments primarily by the hope of getting out of debt sooner. With a right of recast made explicit, they will also view extra payments as a worst-case backstop. The more you pay when you have the means, the larger the payment reduction you can command in an emergency. I can't think of an easier way to motivate homeowners to save more.
• Contact Jack Guttentag via his website at mtgprofessor.com.