One significant problem still facing our housing market is the alternative-A and prime borrowers who are now in a negative equity position; were even 15% of these upside-down homeowners to be foreclosed upon, another 1.5 million-plus units would be added to the housing stock for sale — doubling the coming deluge from subprime borrowers.
A rapid, and inexpensive, way to drastically limit this potential flood is needed.
There is a way to keep hundreds of thousands of underwater families in their homes and slow the decline in housing prices: Reverse the customary accounting for the principal and interest components of a monthly mortgage payment until a zero equity position is reached. It is that simple.
With a fully amortizing home loan, the part of the monthly payment going toward interest slowly falls, and the part going toward principal reduction slowly rises. Devoting the larger portion of the monthly payment to reducing the unpaid principal, instead of the interest, would keep families who are in a negative equity position from defaulting.
Affordable curtailments would accelerate the process, as would devoting the entire monthly payment to lowering the outstanding principal. (This would speed things up by 20%.)
A typical example: Two years ago the median home price was $220,000, and the median annual family income was $55,000. Suppose a family refinanced with 20% ($44,000) equity left. The new mortgage amount is $176,000. A fully amortizing fixed-rate home loan, with an interest rate of 5.75% a year, would mean a monthly payment of $1,030.
In the last two years the median housing price has dropped 25%, to $165,000. In this example, the unpaid balance would be $171,000, making the negative equity $6,000. Of the $1,030 monthly payment, $820 is going toward interest, and $210 is going toward principal reduction. Reversing the accounting would credit the $820 to reducing principal and $210 to paying interest. After only eight months, $7,000 would have been redirected to reducing principal.
With such a short time horizon to parity, the struggling mortgagor would be greatly motivated to hang on and keep the family in their home. This is an outcome we want.
The lost interest is nearly $10,000, compared with a 30% loss severity of $51,000 (0.3 times $171,000). The interest computation was simplified by ignoring the time value of money and the effect of negative amortization.
The situation could be worse. Refinancing with 10% equity left would make the new lien $198,000 and the payment $1,160. After two years the principal balance would be $193,000. With a steeper housing price decline of, say, 30%, the market value would be $154,000, and the revised negative equity position would be $39,000.
Now it would take 3.5 years to become rightside up after an accounting swap. (The monthly payment is $1,160, of which $925 is being credited to interest.) What could curtailments do in this instance?
The family's income was $55,000, with only 25% going to mortgage payments. Stretching this to 38% would permit a monthly curtailment of $590. Now 42 months becomes 26.
Let the servicer decide which alternative-A and prime negative-equity borrowers could be turned around using this plan. It can do so without notifying the investors, because the federal government picks up the tab for the forgone interest and negative amortization.
The investor remains whole, and the property stays off the market. Our cost: $20,000 of forgone interest per loan on 1.5 million loans comes to only $30 billion, rather than $300 billion of "troubled assets."
Putting this idea into force would go far toward preventing unnecessary foreclosures based on negative equity, slowing the decline in housing prices and keeping our costs to a minimum.