There's a Much Better Mortgage, If Only Banks Would Offer It

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A quick perusal of any major bank's mortgage department offerings could easily lead you to believe that the U.S. mortgage market has far too many products for its own good. While it is certainly true that some of the mortgage products being offered seem unnecessary or even designed to increase the likelihood a borrower will experience trouble making payments, there is one mortgage product missing that would be a great benefit to many American home buyers: the flexible term mortgage.

Canada, France, and Japan all have major banks that offer what they variously call flexible term loans or flat payment variable rate mortgages. In fact, several Canadian banks that also do banking business in the U.S. offer this product in Canada. It is a mystery to me why this product is not widely available in the U.S., but we should bring it here as soon as possible. It would provide many benefits to the sort of home buyers who tend to choose adjustable rate mortgages and especially the group within that set that caused many of the problems in our recent mortgage market meltdown.

The traditional American adjustable rate mortgage begins with a teaser rate (which is an artificially low interest rate for some set period of time) and then has an interest rate that is adjusted once per year according to a specified formula. As interest rates change, the monthly payment changes in order to keep the mortgage on schedule to be paid off in some fixed number of years (which is most commonly 30).

This adjustment mechanism means that borrowers almost always see their monthly mortgage payments jump after the initial period (usually one year) and can easily end up with a monthly payment that they cannot afford. Unfortunately, too many borrowers in the early 2000s took out such mortgages with the hope that either their incomes would rise substantially before their payments rose too much or that they would be able to sell their house for a healthy profit and pay off the loan that way. Often, neither happened and we ended up with a surge in foreclosures and tons of toxic mortgage backed securities.

Flexible term mortgages adjust in a different way that allows borrowers to still benefit from the possibility of lower rates (and to avoid the premium charged in fixed interest rate mortgages) without having the unpredictability of an adjustable mortgage payment. Instead, with a flexible term mortgage, when interest rates change, the monthly mortgage payment stays fixed and the number of payments required to pay off the loan adjusts.

So if interest rates fall, a borrower would pay off her mortgage faster; if interest rates rise, it would take longer to pay off the loan. As interest rates change, the amount of the fixed monthly payment needed to cover the interest on the loan changes, so the amount left over to pay down the principle also varies.

This may sound a little like the option mortgage products that were sold before the real estate bubble burst, but it is not the same at all. Option mortgages allow the borrower to pay less at times, even to the point of negative amortization (where the borrower ends up owing more than when he started). Flexible term mortgages have a fixed payment; you make the same payment every month. No option, no choices, just a constant mortgage payment.

Clearly, the big advantage of such a mortgage product is that if the borrower can afford the payment at the time of the loan's inception, she can probably continue to afford that payment. Many borrowers pay the interest premium inherent in a fixed rate mortgage simply to secure the peace of mind that comes with a fixed mortgage payment. With a flexible term mortgage, borrowers can get that same peace of mind with a lower interest rate (and, thus, a lower monthly payment).

The cost of that benefit is the possibility that it will take you longer to pay off your mortgage. However, since 75 percent of American families move within any five year period, for the vast majority of borrowers the adjustable term makes little difference since they will sell the house and pay off the loan long before they reach the end of the mortgage term. In fact, the median payoff time for an American mortgage is slightly less than four years.

Flexible term mortgages are good for borrowers, allowing them to benefit by avoiding the interest rate premium lenders charge for a fixed rate mortgage while they retain the advantage and comfort of a fixed monthly payment. Flexible term mortgages are good for lenders, allowing them to avoid being locked into a fixed interest rate. The increased probability that the loan continues to get paid is an advantage for both parties. The adjustable term of the mortgage will matter to very few borrowers because so few Americans hold a mortgage to completion. If there is a downside, I don't see it.

Adjustable rate mortgages were at the heart of the problems we have had in our real estate and mortgage markets since 2006. For all the interference by regulators in this industry, the regulations seem to have done little to protect any of the parties involved from harm (not borrowers, lenders, or investors).

A much better adjustable mortgage product exists that would provide some useful protection to borrowers without any particular loss on the part of lenders or investors. What we need is a few innovative lenders to start selling flexible term mortgages. I suspect that if given the chance this product could capture significant market share in the U.S.

 

Jeffrey Dorfman is a professor of economics at the University of Georgia, and the author of the e-book, Ending the Era of the Free Lunch

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