Future Mortgage Option: Lending Insurance To Avoid Rate Volatility

This article was originally posted on the GeekEstate Blog:

Imagine you’re one of the millions of Americans who have been locking in in record low interest rates on adjustable rate mortgages within the past few years. 4.0 percent on a 30 year mortgage is a good deal, but 2.25% on a 5 yr ARM, or 2.5% on a 7 yr ARM cuts your payment nearly in half. Since most mortgages are refinanced or the property is sold within a seven year time frame, it seems like a good financial bet.

Still, five to seven years from now you’re not sure where rates will be. Your ARM could reset annually and potentially leave you at a 7.5 percent in an 8-10 year period. If market rates are near 7 percent at that time, your options will be slim.

It would make sense to have a product that alleviates that risk. There seems to be a niche market for lenders, and insurance or investment-related service providers, for a “future mortgage option”.

The idea would be fairly simple and probably highly profitable for the service providers. Allow a homeowner to apply, and pay the fees upfront, for a mortgage refinance at a set point in time in the future. A homeowner could secure a refinance of their home today at 5.0% fixed for 30 years, but delay the actual closing and recording of that mortgage until five years from now. The lender would be locked into an agreement to close that financing at the defined future date. If, upon reaching that date, the homeowners decided the refinance wasn’t worthwhile, they could simply decline the refinance, and forfeit the closing costs that they had paid upfront.

Of course, like anything related to mortgage lending, there would be plenty of risks that need to be addressed.  Here are a just a few:

  • To ensure the financing is still available in the future, the lending institution would need to be insured by a larger organization that could follow through on its obligations in case it goes under.
  • The borrowers would be prohibited from taking on any additional leverage on the home–the balance of the liens against the property at the point of application would have to be the same or lower upon the date when the future mortgage is to be recorded.
  • The 3rd party fees necessary to record the mortgage, collected as part of the closing costs, would have to be held in some kind of reserve account by the lender. It would probably make more sense for the lender to only collect its origination fees or “points” upfront, and then collect the recording-related fees at the future closing date if the homeowners elect to go through with the refinance.
  • The lender would incur the risk of the homeowner’s employment situation changing in the interim.  That’s a risk that every lender takes with long-term mortgages already, though.  Within 30 years, there will inevitably be changes with some borrowers.
  • The lender would incur the risk of market values declining in the interim.  Again, this risk is inherent in any real estate lending.  A company involved in ARM lending is already keenly aware of the profit margins necessary to take on the risk of short-term market depreciation.

This might make the future mortgage option sound like a bit of a niche product. To the homeowner who is making the hedge bet of a low-rate ARM, though, it’s exactly the kind of backup insurance that would be attractive.

We insure everything. Why wouldn’t we pay a few bucks upfront to mitigate the risk that rate volatility creates for our largest monthly expense and our most valuable possession?

Homeowners with today’s ARMs are banking a nearly 40 percent reduction in their mortgage payments.  At the median U.S. home price with a 20 percent down payment, they’re saving almost $20,000 over seven years.  In high cost markets, their savings could easily reach $50,000. Spending a grand or two upfront to ensure that, at year seven, their payments are still reasonably low would be financially responsible.

Lenders would obviously be the primary business beneficiaries of the product, but financial advisers and insurance agents could reasonably offer it as an option to their clients as well. There would certainly be some regulations involved, but there would probably be a way for these service providers to directly partner with lenders in offering the products to customers.

Take it a step further, and consumers could be offered both products at once–an ARM and a future mortgage option. It might require two different lending institutions to be involved, since most lenders love their five percent ARM adjustments and wouldn’t want to gut them with a secondary product. The added income on the future mortgage fees might just be enough to get a single institution to offer both simultaneously, however. Effectively, they’d be creating an ARM with a single fixed adjustment date and rate, and a higher profit margin for closing it.

It’s a somewhat complex product in its implementation, but with our zeal to insure ourselves from any risk in our lives, there are probably a lot of homeowners who would buy into a future mortgage option.