Negative Amortization and Consumption Smoothing

I've been thinking about mortgages recently (mostly out of idle curiosity--I'm not planning on buying a house any time soon). When I first heard about interest-only and negative amortization loans, I thought they were recipes for disaster. But after some additional thought I've realized that they actually make a lot more sense than traditional mortgages.

The aspect of traditional mortgages that strikes me as suboptimal is the fact that the monthly payment is fixed. Fixed for a period of thirty years, during which inflation may reduce the real cost of the payment by a factor of two or three, and during which a combination of inflation and promotions may increase the borrower's nominal income severalfold.

In short, the payment is greatest in real terms when the borrower's income is least. From a consumption-smoothing perspective, this is precisely backwards. At the very least, the payment schedule should allow for inflation, and there's a good case to be made for (conservatively) adjusting it to allow for expected increases in real wages, as well.

I think that the ideal mortgage for most people would be one in which the monthly payment grew by 3-4% per year, or some other conservative estimate of the nominal growth rate of the borrower's income. In a 30-year loan, this would generally result in negative amortization for the first few years, but the payment would quickly grow to the point where it would exceed accrued interest and start chipping away at the principal.

I can see some potential problems with this type of loan:

1. Some people will buy houses so expensive that they can barely make the initial payments. This eliminates any margin of safety, making default almost certain if their incomes fail to grow as quickly as predicted at any point during the next 30 years. This is probably true in some cases, though the desire of lenders not to lose money should help to check this tendency.

2. Children are expensive, perhaps so much so that the amount of money available for housing expenses doesn't actually grow much over the typical person's lifetime. I'm not sure whether this is true, but it is worth noting that renters also have to deal with monthly payments that grow over time, and they seem to be able to handle it.

3. People don't save enough for retirement as it is; if smaller mortgage payments give them extra disposable income now, they'll end up consuming some or all of it. This will reduce total saving and make them even worse off in retirement. Perhaps, but stocks, particularly when held in a tax-deferred retirement account, generally give better returns than paying off a mortgage early. Paying less for your mortgage now and investing the difference has positive expected value.

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Mortgage thoughts

I like the idea of your mortgage scheme, but as someone who closed on a house about a month ago, if I had the option to spend more because I could aford it NOW, I probably would have.
With the fixed rate over the course of the loan, I know what I can afford now and barring losing my job, will continue to be able to aford it in the future. I don't have to gamble on getting a pay raise every year to match my mortgage rate increasing. Plus, The mortgage company wants to make as much interest on your loan as fast as possible and if the payment was less to start with, the MOrtgage company gets screwed if you decide to sell early and you know they don't want that.

Makes a lot of sense to me,

Makes a lot of sense to me, although I still think that money is better off in the stock market than a house. So I believe in interest-only loan until you accumulate enough equity to take a home-equity loan and buy index funds with it :).

The tax-deductability of

The tax-deductability of mortgage interest makes the fixed mortgage payment do to some degree what you describe.

Mortgage Deductions

So it does! I hadn't thought of that. At a 25% tax rate, the after-tax cost of mortgage payments goes up by about a third as the payment goes from mostly interest to mostly principal.