The time has come to have a proper burial for the traditional 30 year fixed rate mortgage (and it’s 20 and 15 year cousins). Rest in peace dear friend as you have helped many a homeowner over the years. However, Father time has won again.
The truth is the thirty year amortized mortgage dates back before the Great Depression. Why it has not been retired yet speaks more to our thinking than anything else. Change is hard even when it is obvious.
Many will argue that there is no reason to change. Or, that the new Consumer Bureau’s rule on qualified residential mortgages makes it a bad time to bury this financial relic. I disagree. There are moments in history that defy conventional wisdom. Moments where events happen faster than we can comprehend. Such is our time. And the speed of economic and social changes will only increase. The type of mortgages used to finance the purchase of a residential property must also evolve.
The following questions, and answers, are central to my thinking as to why the thirty year mortgage has lost its relevancy:
- How long can financial risk be managed in an era of global economic interdependency?
- What impact does a culture of constant refinancing have on reducing risk for banks, capital markets, and homeowners?
- How long will consumers continue to see value in owning a home?
- And, what if strategic defaults (when homeowners turn in the keys) become the accepted norm of walking away from home ownership?
What I am going to propose is a new mortgage and process so that risk can be more effectively addressed. Time is a critical component. Instead of being in mortgage indebtedness forever, the overriding goal should be to retire the loan as soon as possible. As it stands right now, the term may be 30 years, but how many homeowners retire their mortgage?
The 21st century mortgage I propose has several features. First, and most importantly, the term should be directly linked to the borrower’s net qualified income which should not exceed 33% for a total housing allowance or debt to income ratio. For example, if a family’s qualified income fits best for a 22 year mortgage then so be it. Whatever term conforms to debt to income ratios based on net income, the max any term should be 25 years.
The new process I propose would eliminate preset term buckets to drop borrowers into. Also, the income ratios should apply across the board to all loans.
Second, interest rates should be risk based and higher than today’s rates. When we buy health insurance, medical risk factors dictate the premium. Why should mortgages be any different? Addressing high cholesterol or blood pressure, weight gain, and smoking are no different from low personal savings, high debt to income ratios, and self-employed income.
Today’s loans, where higher points and fees are charged up front is a dead-end approach. So is a post origination refinance. Be honest, does refinancing truly lower the risk factors? In my mind, refinancing a loan no more reduces financial risk than a person who loses five pounds when they need to shed 100. Today’s homeowners have no incentive to improve those factors that make their loan risky or even to keep the risk at bay.
Third, a loan should be reviewed by the lending institution and borrower every three years. In lieu of refinancing, what if a mortgage banker sat down with their client and went over their entire financial picture and compared it to the one taken at the last application. If the risk factors have gone down, then a lower interest rate should be the reward. Likewise, if the homeowner has gone backwards then the interest rate should either go up or a slight loan modification enacted. Refinances should be reserved for life events such as divorce where a spouse must be taken off of a loan and/or title or bought out of the house.
Fourth every loan should have built-in modifications at the time of origination. I see no reason why we should wait for missed payments. The modern loan should have a 30 year, interest only and even a below interest payment options. These modifications can only take effect after a homeowner and mortgage banker meet and underwriting reviews the case file. There should never be anything automatic or left up to loan servicing to determine a modification.
Lastly, loans should be based on simple, rather than amortized interest. The amount of principal paid at origination should be contingent on the overall debt to income ratio as well as the goal of retiring the mortgage as soon as possible. It is absolutely insane that borrowers must pay for ten or more years to begin retiring substantial amount of loan principal. True investors will miss out on all that interest, but what about reducing risks and getting out of the boom and bust cycles that characterize housing.
That brings me to the why part of my article. Why would banks and investors consider making this change? Profitability in a word.
I think banks and investors are kidding themselves about the profitability of current loan offerings. At first glance, I am sure the bottom line looks good. But I remember when a boss of mine proved to the Navy how much one bomb cost to deliver from a Navy fighter plane to its target below. The fully loaded cost to drop that one ordinance on an enemy tank ended up being exorbitant.
I believe the same is true for today’s fixed rated mortgages. The costs associated with originating a loan every four to five years due to refinancing, loan guarantee fees, servicing errors, on-going litigation and attorney fees, loan buy backs, inverse yield curves, foreclosures, and now strategic foreclosures begin to shape the picture of a loan’s fully loaded costs. Doesn’t it seem prudent to begin exploring loan programs that are more profitable and less risky?
Why would consumers go for this new loan and process? I think in a word it is value. I submit that homeowners are starting to catch on that paying a mortgage year after year is an unacceptable risk with little reward. Plus the payment is not truly fixed. Property taxes, homeowners insurance, condo and homeowners association fees, and other home-related expenses are constantly on the rise. A “fully loaded” monthly payment is much higher than the principal and interest payment of any loan.
Not only would the loan and follow-up process I propose offer more value and safety, but homeowners could rightly say banks are looking out for them in addition to their bottom line.
Yes, there are risks associated with what I have proposed. I have thought them through and will be writing about them in-depth in the weeks and months ahead. For starters, home values will likely decline since homes will be bought based on true affordability rather than “buying power.” Also, how do all the loans already originated and securitized get transitioned into a new modern program?
The surface is just being scratched here but rest assured, I will continue to challenge conventional wisdom on this topic. I look forward to all constructive comments and suggestions.