Revising the standard mortgage to meet today's challenge

People are living longer, which means they need more wealth when they stop working. One approach to this objective is to find ways to encourage homeowners to pay off their mortgages before they retire. In this way, their full home equity becomes available for conversion into spendable cash if needed.

The existing standard mortgage was not designed to encourage early repayment of the loan balance. Rather, since the 1930s, the public policy objective has been to promote homeownership by making mortgages more affordable. The focus has been on strategies for making the monthly mortgage payment as low as possible, with repayment of the balance left to take care of itself.

This article describes an alternative mortgage design that allows borrowers to manage their loans in ways that are not possible with the existing standard mortgage. This provides stronger inducements to repay the loan balance.

The alternative design

The initial required mortgage payment would be fully amortizing - calculated in the same way as it is now on most existing fixed-rate mortgages. But while future required payments on existing mortgages don't change, future required payments on the alternative design are based on loan balance.

A schedule of required balances, declining month by month over the life of the loan, would be part of the loan contract. 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. Here is an example:

A 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 that 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 $1307.34 to $1,000 starting in year four, he could do it for 39 months before exhausting his reserve.

To realize the full potential of the flexible mortgage, servicing must allow borrowers to make the kinds of calculations shown above. Loan servicing must be interactive so that at any time a borrower can "try out" alternative payment schemes and immediately see the implications for future loan balances and required payments.

Importance of reserve accounts

Anyone who makes an unconditional financial payment commitment extending over many years and wants to live without anxiety about it, maintains a reserve for unexpected contingencies. Mortgage underwriting rules recognize this by requiring loan applicants to have financial assets equal to two to 12 months of monthly payments at time of closing. But after closing, borrowers are stuck with an instrument that prohibits the accumulation of a reserve within the mortgage.

The borrower who pays off most of the mortgage loan balance with her lottery winnings has the same required payment the following month.

The distinguishing feature of the proposed alternative mortgage is that a reserve account under the control of the borrower provides payment flexibility. So long as the actual loan balance remains below the maximum balance, the payment can be anything the borrower wants.

Of course, a borrower with an existing mortgage who has excess funds can always create a reserve account in a bank that can serve the same purpose. The difference is that a reserve account within the mortgage earns the mortgage rate rather than the bank deposit rate.

Further, unlike a bank deposit that can be drawn and spent in a weak moment, a mortgage-based reserve cannot be used for any purpose other than making mortgage payments.

The alternative mortgage and home equity growth

There are three reasons why balances on the proposed mortgage will be paid down faster. First, defaults would be smaller because of the greater inducement to accumulate reserves. Second, unused reserves will automatically result in early payoff. Third, and perhaps most important, the alternative mortgage will dislodge "payment myopia," which is my shorthand term for the widespread practice of basing financial decisions solely on the affordability of monthly payments, without considering how the decisions will affect wealth.

People who are payment myopic all their lives seldom retire with significant wealth. The financial system offers them numerous opportunities for short-term gratification at the expense of the future.

The alternative mortgage discussed here confronts payment myopia head-on by forcing the borrower to focus on the loan balance - not only this month but every month. Interactive servicing that prompts borrowers to confront the future consequences of actions (and inactions) taken today would play a major role.

• Contact Jack Guttentag via his website at mtgprofessor.com.

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