Correction to This Article
In a June 30 Real Estate column, Jack Guttentag omitted a portion of the calculations in an example of why a particular mortgage would be acceptable for a widow who took a mortgage for $1 million at 8 percent, invested the proceeds at 5 percent, and had a net cash inflow of more than $12,000. He neglected to say that in order to bring in that much cash, she bought a fixed-payout annuity on which the payment over five years included the repayment of her $1 million investment.

When 'Unaffordable' Is Good

By Jack Guttentag
Saturday, June 30, 2007

A widespread view among bank regulators, community groups and some legislators is that all home mortgages should be "affordable" and that government should do what is necessary to bring this about.

Last week, I looked at a proposal designed to ensure the affordability of adjustable-rate mortgages. It would require lenders to qualify ARM borrowers not at the initial interest rate but at the fully indexed rate, which more closely approximates the rate at the first and second rate adjustments.

I pointed out that this rule would have little or no force because lenders could evade it with impunity if they wished. Further, it is not at all clear that we would want such a rule to be effective because every foreclosure prevented by the rule would also block a larger number of families from attaining homeownership.

Today, I discuss another shortcoming of the "all loans should be affordable" idea. Some loans that would be classified as unaffordable are clearly in the interest of borrowers. Reverse mortgages for elderly homeowners are an obvious example, but many are not so obvious. The following examples are based on letters from my mailbox.

· Need to stay in the house: The borrower is a widow who owns a house worth $2 million with no mortgage. Her income dropped precipitously when her husband died and is barely enough to pay the property taxes. She plans to live with her children in five years and wants to remain in her house until then.

She could take out an interest-only 30-year, fixed-rate mortgage for $1 million at 8 percent, which costs her $6,666 a month. She then could invest the $1 million to yield 5 percent over five years, generating cash flow of $18,871 a month. Net of the mortgage interest, her cash flow is $12,205 per month for five years, which meets her needs. At the end of five years, she can sell the house and pay off the loan.

This loan is not "affordable," but it is a perfectly sound loan for the lender to make and allows the borrower to maintain her lifestyle.

· Financial emergency: The borrower learns he is going to be laid off in two weeks and will have no income for four to 10 weeks. His financial reserves are not large enough to pay his mortgage during this period, but he has equity in his house. He uses it to take out a second mortgage in the form of a home-equity line of credit, which allows him to stay current on his first mortgage.

The borrower can't afford the credit line when he gets it because he has no income. Nonetheless, it is secured by his house and is paid off along with the first mortgage when he finds a new position.

· Confidence in rising income: The borrower is a young physician with two years of residency remaining. The doctor's annual income now is $50,000, but in two years, it will be at least $150,000. Instead of buying a small house now and then upgrading in two years, which is costly, he wants to buy the larger house now based on the salary expected in two years.

Underwriters will not qualify a borrower using expected future income, no matter how well grounded the expectation is. This borrower's current income is too small to qualify for a loan large enough to purchase the house desired using any of the standard mortgages. However, the physician can qualify with current income using an option ARM on which the initial minimum payment can be calculated at a rate as low as 1 percent. While the payment rises slowly over time and may jump sharply after five years, the borrower will be well prepared for it.

In all these cases, lenders make good loans that are well secured. The first two are "unaffordable" for the borrower at the time they were made. The third would have been unaffordable if the lender had been barred from qualifying the borrower at the low interest rate in month one, as bank regulators have proposed.

If the affordability police force institutional lenders to reject loans of these types, the loans will gravitate to "hard money" lenders. These are mainly individuals who base loan decisions strictly on the collateral, care not a fig about affordability, are outside the reach of any affordability rules and charge very high rates. The prospect that government will require that institutions make only affordable loans makes these lenders drool.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,

© 2007 Jack Guttentag

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