What can a 20-year mortgage do vs. a 30-year, and why does President Obama want one
Though not a traditional route for borrowers, the shorter loan costs less in overall interest. So, more of a monthly payment goes toward principal.
If more widely used it might help housing because underwater homeowners, who owe more on mortgages than their places are worth, would get to the break-even point years sooner with the 20-year. That would smooth the way for easier buying and selling of property, and maybe deter foreclosures and walkaways.
A subsidized version of the 20-year loan is in Obama's latest housing aid proposals. And though pundits are skeptical that the package will pass Congress, the marketplace is apt to see a lot more of the 20-year mortgage anyway.
Housing experts say that within days, a rising number of underwater borrowers should begin to refinance into 20-year mortgages as new loan-writing software arrives.
Some homeowners have already gotten 20-year fixed-rate mortgages over the years. They don't require quite the heft of monthly payment that 15-year loans do. And while one would expect a lower annual percentage rate than on 30-year loans, so far the 20-year variety haven't been aggressively promoted with APRs low enough to draw broad uptake.
The increased refinancing activity among underwater borrowers current on payments should begin to materialize next week, when government-sponsored entities Fannie Mae (OTCBB:FNMA.OB - News) and Freddie Mac (OTCBB:FMCC.OB - News) release new underwriting software. It's tailored to reflect changes made to the government's Home Affordable Refinance Program (HARP) last fall that encouraged refinancing into shorter-term loans and broadened the pool of eligible borrowers.
HARP in both its new and old versions has attracted plenty of criticism as potentially expensive and risky government intervention into the housing market. However, this 20-year loan option in "HARP 2.0" could have wide appeal among those eligible for it.
Roughly 11.1 million mortgages were underwater in the fourth quarter last year, according to real estate data firm CoreLogic (NYSE:CLGX - News). Dan Green, a loan officer with Waterstone Mortgage Corp. in Cincinnati, says he has fielded roughly 100 inquiries a day about the program so far this year.
"I'm just one guy," Green said, "but I can tell you that at the street level there is huge demand for HARP 2.0.
HARP 2.0 officially launched in December. But lenders have had to underwrite HARP mortgages manually. The tedious process leaves lenders more vulnerable to errors and potential liability.
The Federal Housing Finance Agency launched HARP in 2009 and has facilitated refinancing for more than 1 million underwater borrowers, according to Senate testimony last month by Edward DeMarco, FHFA's acting director.
Last fall HARP eligibility was expanded to include homeowners with loan balances exceeding 125% of a home's value — in other words, refinancing those significantly underwater. Officials also created incentives for replacing 30-year mortgages with lower-interest 15-year and 20-year loans by reducing lender fees that are typically passed on to borrowers.
The primary goal is to change the risk profile of the loan, says Keith Gumbinger, vice president of mortgage data firm HSH Associates.
"In theory, a borrower who refinances with a lower interest rate and a lower payment is likely to continue to make payments," he said.
By reducing the term, he adds, borrowers also can pay down principal more quickly. "That could lessen then severity of a loss down the road in the event of a short sale or foreclosure," Gumbinger said.
Lenders that refinance existing borrowers into 20-year loans with lower interest rates could see their income reduced, acknowledges Erin Lantz, director of mortgages at real estate marketplace Zillow (NASDAQ:Z). But in addition to feeling government pressure to help homeowners, lenders recognize that they could lose customers by not offering HARP.
"If there's an opportunity for a borrower to refinance into a better situation, the chances are that the borrower's going to take it," Lantz said. "If it's going to happen anyway, then you might as well offer it yourself.
Still, HARP is only open to borrowers with loans that are guaranteed by Fannie Mae or Freddie Mac and were sold to the GSEs before May 31, 2009.
President Obama has proposed an FHA-backed refinancing program for homeowners with mortgages not guaranteed by the GSEs. Congressional approval, however, is considered unlikely.
While underwater homeowners who apply for HARP loans can choose to refinance into another 30-year mortgage, the 20-year loan offers benefits.
Say a homeowner used a $228,000, 30-year mortgage with a 6.37% fixed interest rate to buy a $240,000 home in March 2006. According to calculations provided by HSH.com, the borrower makes a monthly payment of $1,422 and to date has paid $83,883 in interest.
If the property had lost 30% of its value, it would be worth $168,000 today while the loan balance would be $209,522. Assuming no further depreciation or appreciation, it would take the homeowner until August 2020 to get back above water.
Refinancing with a 20-year mortgage at 4%, however, would allow the borrower to reach equity equilibrium about three years earlier, in September 2017. The new mortgage would also reduce the monthly payment by $152. (The mortgage assumes refinancing fees of $4,000, or about 2% of the loan, but HSH.com notes that HARP borrowers will likely face less cost.) What's more, the 20-year mortgage would pay off four years sooner, and the homeowners could save $104,724 in interest over the loan's life than if they'd kept the old loan.
A new 30-year mortgage at the same 4% interest rate would cut the homeowners' monthly payment by $270 compared with the 20-year loan, but at a $55,385 cost in extra interest payments over the loan's life. Not only would the final payoff be put off by 10 years, but the borrowers wouldn't even be above water until August 2021.
Zillow, meanwhile, calculated the benefits for someone who bought a $400,000 home in July 2006 with a 30-year, $388,000 loan at 6.4%. The homeowner has a monthly payment of $2,427 and has paid $137,726 in interest so far.
Say that the home now appraises at $240,000 — a 40% drop in value — but that it begins appreciating at 3.5% a year starting in May 2013. With a $358,266 loan balance, the owner wouldn't hit equity equilibrium until September 2020.
Refinancing with a 20-year fixed-rate mortgage at 3.7% would allow the borrower to get out from under water by 2018, Zillow says. Monthly payment savings would be $310.