To Make Mortgages Fair, Keep Disclosures To a Page
Wednesday, May 2, 2007
A simple summary is the best way to make sure borrowers understand their loans.
The sub-prime mortgage boom has turned predictably to bust. When politicians think about borrowers who are in financial trouble, whether from being induced into loans through misrepresentation, not understanding the loans, or simply making unwise choices, they naturally want to protect them. One political thought is to introduce new restrictions on what kinds of loans can be offered.
A superior strategy is to equip borrowers to protect themselves by requiring short, simple, and clear disclosures of mortgage loan terms and their relation to household income. The borrowers can then in effect “underwrite themselves” and understand their basic risks. They have the natural incentive to do so—we need to add intelligible, practical information.
I believe there should be a required one page form which gives the essentials of the loan, which should be given to every mortgage borrower three days before the closing.
Ironically, past regulatory attempts to insure full disclosure have made the problem worse.
A good mortgage lender wants a borrower who understands how the loan will work. This is especially true since a mortgage is by far the largest debt obligation of the typical American family. The borrower should understand what the financial commitments of the loan agreement are, including any possible future interest rate increases and prepayment penalties. The total financial obligation needs to be put in the context of the borrower’s income.
Current American mortgage loan documents certainly do not achieve this. Most of us have had the experience of being overwhelmed and befuddled by the huge stack of documents full of confusing language in small print presented to us for signature at a mortgage closing. The complexity results from legal and compliance requirements. Ironically, past regulatory attempts to insure full disclosure have made the problem worse.
To achieve an informed and understanding borrower, the key information must be simply stated and clear: 90 percent of the relevant information which is clear and understandable is far better than 100 percent which is complex and opaque. Trying to describe the loan in specific legal and bureaucratic terms (which principally protect the lender) results in essentially zero information transfer to the borrower.
The one-page form should include key underwriting concepts, including the borrower’s income and housing expense ratio, as well as the principal loan terms. The “housing expense ratio” means the sum of the monthly interest payment, principal repayment, property tax, and house insurance premium, expressed as a percent of the borrower’s monthly income. This should be shown both for the beginning interest rate and for the fully-indexed interest rate. In typical types of sub-prime loans, the fully-indexed expense ratio can be a remarkably larger financial burden than the initial or “teaser” rate suggests.
I propose the following one-page “Basic Facts About Your Mortgage Loan” form, with the accompanying common sense explanations, along with a little avuncular guidance:
Comments and suggestions for improvement are welcome at firstname.lastname@example.org. Suggestions which would expand the form beyond one page or make the type small will not be accepted.
Alex J. Pollock is a Resident Fellow at the American Enterprise Institute.