By: Jack Guttentag
A mortgage recast is an adjustment in the monthly payment that makes the payment fully amortizing. The recast will be a payment increase when the existing payment is less than fully amortizing, and a payment decrease when the existing payment is more than fully amortizing.
For example, let's say your home loan has a balance of $100,000 at 5 percent with 300 months to go and a payment of $450 that, if continued, will not pay off the balance. The payment recast is an increase to $584.60, which will fully amortize the balance over 300 months. However, if the current payment was $650, the recast would be a payment decrease to $584.60.
Payment-increase recasts occur on two kinds of mortgages. One carries an interest-only option, where the required payment for some initial period, often 10 years, covers only the interest. The payment-increase recast occurs at the end of the interest-only period.
The second type of mortgage open to a payment-increase recast is the adjustable-rate mortgage (ARM) that allows payments that are less than fully amortizing. These ARMs sometimes have recasts at specified intervals, often every five years, or the recast may be triggered by the loan balance reaching some limiting value, such as 110 percent of the original loan amount. This can happen at any time, or it may not happen at all.
Payment-increase recasts are designed to protect the interest of the lender by making sure that the loan will pay off as scheduled. All interest-only loans and all ARMs that allow payments that are less than fully amortizing have explicit provisions for recasts in the loan contract.
Provisions for payment-decrease recasts, in contrast, which are designed to meet the needs of borrowers, are not included in loan contracts. The lender can agree to a recast; can agree subject to a charge, which can range from nominal to extortionate; or can refuse it. I have encountered all three such responses.
The borrowers who request recasts usually have fixed-rate mortgages (FRMs) on which they have been making extra payments in order to pay off before term, and then unexpectedly encounter a financial reversal. With their income reduced, their objective shifts from paying off early to reducing the payment, for which purpose they need a recast. They deserve it, and the cost to the lender is nominal, but some lenders will take advantage of them just because they can.
The borrower's right to a payment-reducing recast ought to be mandatory for all home mortgage contracts. Borrowers should not have to grovel for what can be critically important to them and of little consequence to lenders. Making recasts into a right would have the side benefit of encouraging borrowers to make extra payments as a form of contingency insurance.
Note that payment-reducing recasts are needed for fixed-rate mortgages much more than for ARMs. The reason is that when the interest rate is adjusted on an ARM, the payment is automatically recast. On ARMs that reset the rate every year, no additional recasts are needed. On ARMs with initial rate periods of 5-10 years, however, the need for a recast can arise in the early years just as it does on FRMs.
Today, borrowers are motivated to make extra payments primarily with the hope of getting out of debt sooner. With a right of recast made explicit, they will also view extra payments as a worst-case backstop. The more you pay when you have the means, the larger the payment reduction you can command in an emergency. I can't think of an easier way to motivate consumers to save more.
Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania.