11/05/2014 06:10 pm ET Updated Jan 05, 2015

Is the Wealth-Builder Mortgage All Smoke and Mirrors?

"What do you think of the new Wealth-Builder mortgage that has gotten a lot of press?"

The developers of the Wealth-Builder (WB), Edward Pinto and Stephen Oliner of the American Enterprise Institute view the 30-year mortgage that today dominates the market as badly flawed. Their view is that it takes too long to accumulate significant wealth, and too many bad things can happen in the meantime that jeopardize that goal. The WB would have a term of only 15 years.

Here are some figures that illustrate their point. On October 23, I shopped the market as a potential home buyer with a 740 credit score who could make a 20% down payment on a $250,000 single-family house. The $200,000 loan I needed was available for 30 years at 3.75%, or for 15years at 2.875%. If I took the 30-year loan, after 8 years of making payments, my balance would be down by $33,663, or by only 17%; if I took the 15, my balance would be down by $99,936 or by 48% -- almost 3 times as much wealth accumulation.

The much larger pay-down on the 15 reflects both the lower rate, and the larger payment: $1369 as compare d to $926 on the 30. It is this lower payment on the 30 that attracts borrowers to it.

The objective of those developing the WB is to combine the more rapid wealth accumulation of the 15 with a payment that is "almost as low" as that of the 30. The only way to reduce the payment on a 15-year mortgage without reducing the loan amount is by reducing the interest rate. This raises two questions. How large a rate reduction would be needed, and where would it come from?

On the first question, I have scoured all the documents on WB I could find, and none mentioned the reduction in interest rate required to make the payment "almost as low" as that on a 30. I decided, therefore, to check it out myself using the lowest available prices on 15s and 30s quoted by the lenders who compete for loans on my web site. Because prices are reset every day, readers who want to check it out for themselves can do it by clicking on Prices of Different Mortgage Types.

On the day I did it, the payment of $1369 on the 15 in my example was 47.8% higher than the payment of $926 on the 30. Let's assume that a payment on the 15 that is "almost as low" as the payment on a 30 is 10% higher, or $1019. But this payment would require an interest rate of minus 1.13%, which is not possible. If we raise the target payment on the 15 to 20% above the payment on a 30, or to $1,111, the required rate on the 15 is zero, and that is not possible either. Conclusion: There is no possible way to reduce the payment on the 15 to anything close to the payment on a 30 through a reduction in the interest rate.

Let's go to question 2: where would any rate reduction come from? The source is a cash payment by the borrower to the lender of money that would otherwise have been used as the down payment. Instead of down payment, it is paid as points that "buy down" the interest rate. This has the unfortunate effect of reducing the borrower's equity in the house at the outset, so he begins with less equity using the WB than if he took the 30. This is not a good beginning for a program designed to accelerate wealth accumulation.

The other consequence of converting down payment into points that buy down the interest rate is increased default risk to the lender. We know that smaller down payments result in more defaults. The developers of WB would deal with this by changing underwriting rules in ways that would reduce risk, offsetting the effect of lower down payments. They propose to replace the current limits on debt-to-income ratios with evaluations of the borrower's entire budget.

While this would indeed be a step forward, down payment requirements and debt-to-income requirements deal with two different aspects of risk, and strengthening the second cannot fully offset a weakening of the first. Furthermore, the problem of stupid underwriting rules applies to the entire market; fixing the rules only for the WB makes no sense.

Of course, lenders could reduce the interest rate at their own expense, in effect subsidizing the transaction, or Governments could pay the points required to buy down the rate. But then WB becomes a subsidy program, and it should be evaluated as such and compared to alternative subsidy programs.

I hasten to add that I believe the current mortgage design is in many respects obsolete and badly needs an upgrade. But the WB is not it. I will be writing about more promising models in the weeks to come.

You can contact the professor at