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Jack M. Guttentag The Mortgage Professor

Jack M. Guttentag, The Mortgage Professor

Pay Big Now, Pay Little Later?

by Jack M. Guttentag

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Posted on Wednesday, December 26, 2007, 12:00AM

If you're hoping for a mortgage on which the monthly payment drops following a large payment to principal, you're not alone. Many borrowers would like this kind of loan; they may have a highly irregular income, or they may anticipate a windfall from a source such as a bonus, bequest, or insurance settlement.

Mortgages fall into four categories with regard to how responsive they are to this need. Standard fixed-rate mortgages (FRMs) are the least responsive; next come standard adjustable-rate mortgages (ARMs), then any FRM or ARM with an interest-only option. Finally, the most responsive is the Home Ownership Accelerator (HOA).

The FRM Option

Extra payments on an FRM shorten the payoff period but do not affect the monthly payment.

For example, if you borrow $100,000 for 30 years at 6 percent, your fully amortizing payment is $599.56. Pay this amount every month and you'll pay off the loan in 30 years. If you make an extra payment of $10,000 in month two, your payment in month three and all subsequent months remains $599.56. Your loan will pay off in month 280, but until then, you will receive no payment relief.

Of course, the lender can always agree to modify the contract, and some will do it for a fee. In the previous example, the payment could be dropped to $539.48, which is the fully amortizing payment that will pay off the loan over the original 30 years.

The ARMS Choice

With an ARM on which the borrower is making the fully amortizing payment, extra payments do change the monthly payment, but not until the next rate adjustment. At that point, the payment is recalculated using the reduced balance and the original term.

Assume that the $100,000 6 percent loan is a three-year ARM, and that an extra payment of $10,000 is made in month two. The payment would remain at $599.56 through month 36. In month 37, assuming the rate stayed at 6 percent, the payment would drop to $525.62. That is the new fully amortizing payment over the original term.

On ARMs with longer initial rate periods, the drop in payment following an extra payment would be further delayed. On the popular five-year ARM, for example, the payment wouldn't drop until month 61.

ARMs become more responsive after the initial rate period ends, because rate and payment adjustments then occur more frequently - in most cases, every year or very six months.

The Interest-Only Scenario

If a loan is interest-only, the payment should decline in the month following an extra payment, whether the loan is fixed-rate or adjustable-rate. The interest-only payment on the $100,000 loan at 6 percent is $500. Following the payment of $10,000 in month two, the interest-only payment should drop to $450 in month three.

There are several caveats to this sensitivity, however. One is that this particular situation doesn't always work the way it should because not all servicing systems can handle it properly. In some cases, the required new payment is properly calculated but the new amount has not been communicated to the borrower. In other cases, the payment adjustment is delayed, sometimes for a year, sometimes for longer.

Of course, if it is an ARM, the payment will adjust when the rate adjusts. If it is fixed-rate, however, the payment may not change until the end of the interest-only period, which would be five or 10 years.

Whether the mortgage is FRM or ARM, after the end of the interest-only period, payment responsiveness disappears. After that, each one is like any other FRM or ARM.

If you are contemplating an interest-only loan and find immediate payment adjustments in response to extra payments a highly desirable feature, don't expect the subject to be volunteered by the loan officer or mortgage broker. They are not involved in loan servicing and will likely not bring up the subject; make sure that you do.

Your Best Bet: The HOA

The most responsive type of mortgage is the HOA, because it has no required payment, only a maximum balance. So long as the actual balance is lower than the maximum, the borrower need make no payment at all.

HOA borrowers who make lump sum payments to reduce the balance and want to reduce payments to the fully amortizing level can just go ahead and do it. While the HOA servicer will not tell them what that new payment is (I am told that this will be remedied at some point), it is very easy to find that number using my calculator 7a.

Because HOA is an ARM that adjusts monthly, the fully amortizing payment will change a little every month, so borrowers who want to stay on track ought to repeat the exercise periodically.

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  • Yahoo! Finance User - Wednesday, January 2, 2008, 1:11PM ET  Report Abuse

    • Overall: 1/5

    The professor seems to have left out a Huge Detail. After the fixed period on ARMs, if interest rates start shooting up as they are now, then the monthly cost may be significantly higher. In cases such as this where the homeowner cannot afford the higher payment, the odds increase dramatically towards having to foreclose and lose the house. This is true that the HOA is the most responsive but it is like any other variable in the sense that the risk is high when mortgage rates go up. Typically, this type is for people with a lot of cash. For the typical homeowner that makes a fixed salary ( annual increases to cover inflation), the safest type of loan is the fixed or FRM option.

  • Yahoo! Finance User - Wednesday, January 2, 2008, 12:28PM ET  Report Abuse

    • Overall: 1/5

    A 5th grader knows better than this so called professors that "HOA" is a trap.

  • Yahoo! Finance User - Tuesday, January 1, 2008, 11:09PM ET  Report Abuse

    • Overall: 1/5

    The advice Professor Guttentag provides is very poor. I have been reading the professor's sputterings for quite some time now. He is barely conscious of how the mortgage market works. I advise all readers seeking accurate information to stay far away.

  • Yahoo! Finance User - Tuesday, January 1, 2008, 5:57PM ET  Report Abuse

    • Overall: 1/5

    This article is misleading the public into thinking the HOA loan is the most economical loan. It's not . In the long run 20 or 30 years the home owner will be paying more interest for their home than they would by prepaying a Fixed loan. The "devil is in the details". opening costs, closing costs and prepayment penalities. IMO the best loan is a fixed loan for 30 years .

  • Yahoo! Finance User - Monday, December 31, 2007, 7:29PM ET  Report Abuse

    • Overall: 4/5

    The comments are surprising. The professor is not recommending the HOA product as the best, he is suggesting it may be the best bet for those who want a mortgage product which recalculates the payments once a large sum is added to principal balance. The product descriptions are precise and the logic is accurate. Unfortunately, most of Yahoo readers appear to be stuck in their own world and want others to be stuck with them. Personally, I do not agree with professor's product of choice to achieve the stated goal (HOA). In my opinion a 30 year Interest-Only loan would work better - lower rate than HOA, and it is fixed. But each product has pros and cons, and borrowers have different needs, thus it is only an opinion. Roman Shulman, Superior Funding Corporation, www.sfcorp.net

  • Yahoo! Finance User - Monday, December 31, 2007, 4:22PM ET  Report Abuse

    • Overall: 3/5

    I have never done mortgage before. Usually I just pay it off without applying for any mortgage. Mortgage is for the poor people like others. ^.^

  • Yahoo! Finance User - Monday, December 31, 2007, 1:17PM ET  Report Abuse

    • Overall: 1/5

    I would venture to guess that Jack settled the lawsuit quietly with this article. Recommending a risky loan product only designed for a small audience on a public site like Y! Finance - very irresponsible.

  • Yahoo! Finance User - Monday, December 31, 2007, 12:14PM ET  Report Abuse

    • Overall: 5/5

    Hmm, interesting comments. You accuse a professor emeritus in Finance of being a crook and unethical for pointing out a positive feature on a very misunderstood mortgage product. I wonder if he recommended a straight 30Yr Fixed for all borrowers if you'd agree with that?? Financially savvy borrowers understand what a powerful tool the HOA mortgage can be. It is NOT for everyone, but definitely makes sense for some borrowers. It will allow you to pay down your mortgage faster and it does provide way more flexibility than a standard fixed rate mortgage. But go on thinking that Guttentag is a crook and keep your 30Yr FRM. Those of us who understand the product and its benefits will accumulate significantly more wealth than borrowers with that archaic thinking. Those of you who criticize the HOA loan, do you understand how it works?

  • Yahoo! Finance User - Monday, December 31, 2007, 11:30AM ET  Report Abuse

    • Overall: 5/5

    If everyone paid off their mortgage on or ahead of schedule as Guttentag is discussing there would be no mortgage crisis, so I also don't understand the anger in regard to this excellent article. I have a fixed rate 30 year interest-only mortgage and am paying down the principal early, and I can tell you it is a wonderful thing for ones' cash flow to get those payments lower on a monthly basis. I've run the numbers of my personal financial options many different ways and reducing debt to zero as quickly as possible always trumps carrying the debt, in any reality-based investment scenario. The additional cash flow thereby gained and not needed for servicing debt can be reinvested, or used for any purpose like upgrades to the home which will in turn increase it's value. If you look at the total cost of buying a home including your interest payments over the years, paying the mortgage off early is actually the cheapest way to buy the home. I personally do not buy the argument that one should carry large debt in order to keep the 2% spread between an average 8% return in equities versus a 6% mortgage. While I do not know the particulars of an HOA loan and can't specifically comment on that type of loan, I do think any article that promotes discussion of paying off debt early is a good one, especially in the current credit climate.

  • Yahoo! Finance User - Monday, December 31, 2007, 9:45AM ET  Report Abuse

    • Overall: 3/5

    Paying down a mortgage is fine if you are not a disciplined saver or if you are a very conservative saver. A mortgage is a long-term debt with a tax deductible interest rate that is lower than any other form of personal debt. It is also lower than the average rate of return most of us earn on our long term investments (i.e. IRAs, 401ks). Before paying down a mortgage, one should first pay down all other debt, including credit cards, auto loans, loans against 401ks and perhaps even home equity lines of credit. Next, maximize all long term savings opportunities, including $15,500 in your 401k, $4,000 in a Roth or Traditional IRA, depending on your eligibility. A non-deductible traditional IRA is still worthwhile for any income level because in 2010, you will be able to convert these to a Roth. If you have maximized all savings opportunities, I would still evaluate whether your average rate of return on long-term investments is higher than your mortgage interest rate. The most accurate measure of your financial well being is your net worth, which is assets less liabilities. If your assets are growing at a faster rate than your liabilities, your new worth is growing. In other words, I would not liquidate $100,000 from my 401k that has averaged 8% over 10 years to pay down my 30 year mortgage that has a 5 or 6% rate. Another reason for not paying down your mortage is you would lose tax deductions on gifts to charities and taxes paid, thereby increasing your annual taxes for federal and state. Just food for thought for those of you who don't spend everything you make.

  • Yahoo! Finance User - Monday, December 31, 2007, 8:32AM ET  Report Abuse

    • Overall: 1/5

    Worrying about artificially lowering ones monthly payment is horribly bad advice with HOAs and variable rate mortgages. This kind of thinking is what caused the the mortgage meltdown we are now experiencing. The erstwhile Penelope Drunk may have been silly and goofy but at least she wasnt offering advice thats a one way ticket to the poor house. People need to go back to the days of buying houses they can actually afford - even if they are fixer uppers that need alot of time, work and sweat equity. Too many people start out by buying houses they can barely afford. Guten tag? Nope, its not a good day with bad advice like this.

  • Yahoo! Finance User - Sunday, December 30, 2007, 10:41PM ET  Report Abuse

    • Overall: 3/5

    To all who doubt Mr. Guttentag's credentials, may I say that I've been reading his articles in the Sunday Los Angeles Times, Real Estate Section, for many years now. He is an accomplished scholar with regard with to real estate matters and I have learned a more than a few tricks about real estate investing from him. Here, he is simply discussing a little-known mortgage that may be useful to a small percentage of the home-buying public. As he is new to Yahoo! Finance, I do hope all the folks who somehow think he has some ulterior or sinister motives will withhold their judgment until he has submitted at least a few more articles.

  • Yahoo! Finance User - Sunday, December 30, 2007, 8:58PM ET  Report Abuse

    • Overall: 4/5

    This is very helpful; as I do pay extra. My hope is that it will help me retire early. Will is work?

  • Yahoo! Finance User - Sunday, December 30, 2007, 6:10PM ET  Report Abuse

    • Overall: 2/5

    Its not the mortgauges that are the problem, the houses are still priced to high relative to incomes.

  • Yahoo! Finance User - Sunday, December 30, 2007, 5:27PM ET  Report Abuse

    • Overall: 4/5

    The article is aimed at people that plan to lower monthly payments by making large irregular payments. The purpose is stated very clearly in the first paragraph. The article doesn't state or imply that an HOA is the best mortgage vehicle for the majority of people - it states that it's the best mortgage program if your primary concern is lowering your monthly payments with large irregular payments. I have no immediate need for an HOA, but appreciate knowing the option exists. Why do so many people bother reading online financial articles when they obviously don't take the time to actually understand the articles? Their time would be better spend re-reading the articles rather than leaving unfounded reviews.

  • Yahoo! Finance User - Sunday, December 30, 2007, 4:03PM ET  Report Abuse

    • Overall: 1/5

    Yet another great "expert"!

  • Yahoo! Finance User - Sunday, December 30, 2007, 3:22PM ET  Report Abuse

    • Overall: 3/5

    Why all of the anger? Are the above commentors the same morons who borrow to the hilt and then blame their mortgage? The author is simply presenting another OPTION to CERTAIN people who have periodic influxes of EXTRA CASH that they would like to apply to their mortgage, and by doing so, lower their payment, while not decreasing their term. Please read the article. If you choose the wrong mortgage, borrow too much, or are paying twice the prime rate, it is YOUR FAULT.

  • Yahoo! Finance User - Sunday, December 30, 2007, 2:30PM ET  Report Abuse

    • Overall: 1/5

    Guttentag, you should be prosecuted for fraud for peddling yourself as an expert. What you have recommended is an option that allows folks to ignore their mortgage problem until it becomes a true crisis. I hope that you have a financial stake in HOA mortgages, because while not disclosing that makes you a crook, it at least means that you are not the idiotic rodent you appear to be.

  • Yahoo! Finance User - Sunday, December 30, 2007, 1:31PM ET  Report Abuse

    • Overall: 1/5

    It's simply insane to call "your best bet" and ARM mortgage that adjusts monthly. It makes you wander what kind of an "expert" the author is and how he is compensated for his wisdom

  • Yahoo! Finance User - Sunday, December 30, 2007, 11:18AM ET  Report Abuse

    • Overall: 1/5

    I think it's irresponsible to recommend another risky mortgage in this environment. I smell something fishy too.

  • Yahoo! Finance User - Sunday, December 30, 2007, 11:16AM ET  Report Abuse

    • Overall: 4/5

    A few people need to reread this article. This is only about lowering your monthly mortgage payment. This is not about paying less over term or decreasing the term.

  • Yahoo! Finance User - Sunday, December 30, 2007, 10:08AM ET  Report Abuse

    • Overall: 4/5

    Apparently some of you don't read for context very well. The HOA is being proposed as a loan that the payments will drop following a large payment. Obviously it has other risks, but it will do what is proposed in the first few lines of the article.

  • Yahoo! Finance User - Sunday, December 30, 2007, 8:46AM ET  Report Abuse

    • Overall: 1/5

    You should mention something about the pros/cons concerning paying off a 6% mortgage with a financial windfall rather than investing that money in a potentially higher return investment... Considering all the tax breaks you get for paying a mortgage, someone might find it better to leave their FRM as is and put the $10k they stumble upon into an index fund or something.

  • Yahoo! Finance User - Sunday, December 30, 2007, 8:40AM ET  Report Abuse

    • Overall: 5/5

    From the article, I don't any promotion on behalf of the professor for any kind of mortgage product. The evaluation looks very abstract and impartial. HOA's are not for everyone! They are specific instruments that, if used by financially conscious homeowners, are very powerful cashflow tools. On the other side, in the hands of undisciplined or unsuitable borrowers, they do more harm than good. Same goes for credit cards! Variable rates are not necessarely bad, either. Promoting them to the wrong user without regard to his or her ability to fully understand the risk is!

  • Yahoo! Finance User - Sunday, December 30, 2007, 2:20AM ET  Report Abuse

    • Overall: 1/5

    Very few people would benifit from an HOA type mortgage. Unfortunately there are many scams out there pushing this type of mortgage saying it "saves you thousands in interest." Paying down your mortgage principle as fast as possible is what saves you interest and you can do that with a regular FRM without the danger of a variable rate. No need to pay anyone to refi to an HOA or buy expensive software.

  • Yahoo! Finance User - Sunday, December 30, 2007, 12:27AM ET  Report Abuse

    • Overall: 1/5

    Sorry, my vote is with sgerenser on this one. I smell a kickback here. I see very little that you can't accomplish by just sending in extra money on your 30 year fixed. Buying points to get the margin down isn't a big deal. You can do that on a 30 year fixed as well. I do see the beneift of having some flexibility, but I think that it is more than offset by the additional risk that you are taking by signing up for a variable rate. I have no idea what rates are going to do over the next ten years, but I'm not gambling my house that we won't see another inflationary spike like we did in the 70's. In short, interesting product, but one that I think the vast majority of home owners should stay away from. Recommending it as a "best bet" is malpractice.

  • Yahoo! Finance User - Saturday, December 29, 2007, 8:55PM ET  Report Abuse

    • Overall: 4/5

    Very good explanation of how additional payments towards mortgage is handled for different types of loan.

  • Yahoo! Finance User - Saturday, December 29, 2007, 8:12PM ET  Report Abuse

    • Overall: 5/5

    Excellent advise Professor. To the joker (sgerenser) that questioned your integrity, it is that person that needs to re-read that article in the Seattle Times. Sgerenser is exactly the type of borrower that unethical Mortgage Brokers salivate over because they think that it's all about rate. What this person fails to understand os that Rate is only 1 component of your mortgage, and if you are in an Accelerator loan, it can be a minor component. Who cares what the rate is if it is being applied to a lower principal balance each month (I exaggerate to illustrate a point)? Would you rather pay 8% on a $100,000 balance or 6% on a $150,000 balance? Not only that, but with the HOA, you are actually paying prinicipal first, not interest! That's one of the main reasons it is so effective. While the HOA is not for everyone, if you are disciplined and won't use your equity for silly things, you can easily pay-off in well under 1/2 the time - depending on your cash-flow - while saving tens or even hundreds of thousands in interest charges. Regardless if it is a 1st or 2nd position HELOC, it can always be dangerous if you spend the equity in your home frivolously. Again, this is the case in a 2nd mortgage or a 1st mortgage -- so what is the difference? Finally, sgerenser is also wrong about what the rate is (even though the rate is not as important as he will have you believe). LIBOR is a stable index that outside of the 1980's has been at or below about 6%. If you buy your margin down to .75% with the Accelerator loan, currently your fully-indexed rate (Index plus the margin) is LESS THAN 6%!! That is lower that the 30 year fixed rate right now!!! How is this a bad loan (for those that get it)? If you have positive cash flow (even modestly positive - 10%) and have a $300,000 mortgage you will save hundreds of thousands of dollars in interest vs. sgerensers 30 year fixed with the HOA and the lowest margin!! Uh, yeah. I think the Mortgage Professor wins this discussion, hands down.

  • Yahoo! Finance User - Saturday, December 29, 2007, 7:54PM ET  Report Abuse

    • Overall: 1/5

    Little to no discussion of the risks of the HOA - very poor. This is exactly what homeowners need - easy access to cash with little accountability.

  • Yahoo! Finance User - Saturday, December 29, 2007, 7:26PM ET  Report Abuse

    • Overall: 1/5

    Your advice is atrociously bad. The Home Ownership Accelerator loan is a bad deal for almost everyone. Sure, your monthly payment might be "flexible," but what good does that do when you're paying a much higher interest rate? The HOA is essentially a 30-year Home Equity Line of Credit. Like a HELOC, the rate is higher than most fixed-rate mortgages. While there may be some people that can benefit from something like this, the vast majority of people would be better off with a 30-year FRM, perhaps with a HELOC on top to be tapped only for emergencies. Read for more information: http://seattletimes.nwsource.com/html/businesstechnology/2003069091_stupidinvestment18.html I just can't fathom why someone who is supposedly the "Mortgage Professor" is advocating such blatantly bad advice. Are you getting paid to push this program?

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