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Thus, Monday’s announcement by Ed Pinto of the American Enterprise Institute (AEI) and Bruce Marks of the Neighborhood Assistance Corporation of America (NACA), commands our attention with a new idea worth considering: the Wealth Building Home Loan. In conjunction with Bank of America, Pinto and Marks announced at the American Mortgage Conference in Raleigh, N.C., that they are piloting a new approach to housing finance and wealth-building for low- and moderate-income families.

While homeownership has been advocated by many as a means of wealth building for low- and moderate-income families, the reality has fallen short of expectations. One reason is the encouragement from all corners that families buy the most expensive house possible at the lowest monthly payment by combining low down payments with 30-year mortgages. These highly leveraged loans produce a lengthy period of credit risk to the mortgage investor and result in a very slow process of equity building, as most of the monthly payments in the first decade or even longer go toward paying interest, with only a small portion paying down principal. Further, homeowners are saddled with payments for 30 years, assuming they never move or refinance. Of course, most families do both. As a result, they typically spend far more in interest than on paying down the amount borrowed. Thus, wealth building relies upon real increases in house prices, yet these can be quite volatile and their long-term growth substantially lags that of other investments.

As a general example, a $150,000 mortgage financed at 4.5 percent for 30 years has a monthly payment of $760. After five years, the borrower has paid nearly $33,000 in interest but reduced the principal balance by only $13,000. In contrast, a 15-year mortgage, with a lower interest rate of 3.75 percent, would require a monthly payment of $1,090, or $330 per month more than the 30-year mortgage. Yet, after five years the borrower would have paid about $25,000 in interest and reduced the loan balance by $42,000. The challenge addressed by Pinto’s framework is how to maintain the wealth-building benefit of the 15-year mortgage while shrinking the large monthly payment difference between the 15-year and 30-year amortization schedules.

Pinto’s concept, being piloted by Marks, has four basic components. While none of them are new, they are being combined in an innovative way. Here’s how AEI’s Wealth Building Home Loan works:

The borrower takes a 15-year, fixed-rate mortgage rather than a 30-year mortgage. This means the homebuyer pays far less in interest over the life of the loan.

The borrower makes no down payment, but pays for closing costs and perhaps assists with “buying down” the interest rate. The loan is underwritten to prudent standards. The faster amortization of the 15-year loan and the robust underwriting offsets the heightened credit risk resulting from the lack of down payment. According to Pinto, the program allows for a broad credit box, making mortgage credit available to a wide range of prospective buyers.

A combination of borrower funds and third-party resources (in the pilot, supplied by NACA and Bank of America) are used to “buy down” the interest rate. This is like a prepayment of interest to the lender in exchange for a lower borrowing rate. This lowers the monthly payment even further and is a key element to reducing the monthly payment difference between a standard 15-year versus 30-year mortgage.

The lender has more flexibility in underwriting, given the combination of the first three features. Moreover, it gives the borrower greater opportunity for wealth building through the faster amortization and reduced interest payments. Pinto also describes how these features better serve the life-cycle needs of borrowers, providing them with resources for their children’s education and for their own retirement.

Since there is no free lunch, there are a couple of other features that must be noted. First, this approach may result in the borrower not being eligible for quite as expensive a house as one with a 30-year mortgage. But the financial risk to both the family and the lender is also much reduced, and the family will build wealth much faster. Second, the lack of a down payment is a clear up-front risk. While the program emphasizes prudent underwriting to ensure the borrower’s ability to make payments and rapid amortization to build equity immediately, a lack of initial equity and low credit scores may require robust financial counseling and careful monitoring for some borrowers. NACA has such programs in place but other lenders may not.