Suboptimizing the Total Return on Mortgages: Are Borrowers Allowed to Pay Their Own Property Taxes?
Bernardi, Richard A., The Journal of Bank Cost & Management Accounting
The current research investigates cash flows to a bank making mortgage loans to determine the effects on revenue of policy decisions involving escrow accounts. The analysis indicates that loan officers may be making suboptimal decisions by adhering to rigid policies in times of declining interest rates. The methodology developed in this research suggests an approach to obtaining a balance between mortgage rates and escrow accounts.
In an economy where interest rates on mortgages are declining, borrowers are inclined to refinance their home mortgages. Given this, if banks desire to maximize the return on borrowed capital, they should attempt to avoid situations that encourage borrowers to refinance mortgages at lower interest rates. This would prevent the bank from losing a mortgage account with a higher than current market rate and having to lend the capital at the current rate.
This research was motivated when the author asked his bank to allow him to pay his own property taxes. The response from the bank loan officer was that since this was not provided for in the original loan contract, the bank's policy was not to allow the mortgagee to assume these payments. The remainder of this paper investigates one method that banks could use to maintain mortgages at rates higher than the current market rate.
Banks hold that the reason for their collecting the escrow payments is to ensure that property taxes are paid and the bank does not lose money if the property is seized for nonpayment of taxes. While in the early years of a loan this may be a wise policy, the necessity of this procedure in the later years of a loan is questionable. In a period of inflation, the property should appreciate in value, provided the house is well maintained; thus, the bank stands little chance of losing money on a seizure auction for nonpayment of taxes.
For example, a couple purchased a home in 1978 for $60,000 paying five percent in cash and financing the remaining $57,000 with a 30 year mortgage at 9.5 percent interest. Fifteen years later, in 1993, they still owe approximately $50,000 on their mortgage. In the same period, the consumer price index increased from 66 to 144 (Council of Economic Advisors, 1993), so that the value of the house would be nearly $131,000 considering inflation.(1) Should the couple default on the loan or fail to make their property tax payments, the bank should be able to obtain their remaining equity ($50,000) from the sale of the house.
Then, why do banks insist on paying property taxes through an escrow account beyond the point where their equity is secure? The answer is simple: the differential between the rate paid on the escrow account and the current passbook rate amounts to additional interest paid by the mortgagee. In the previous example, assume the yearly escrow payments were $5,000. If the interest paid on escrow is 1.5 percent and the average passbook rate is 4.5 percent (i.e., a three percent difference), the $75 ($2,500 average escrow balance x .03) difference in interest paid amounts to a 0.15 percent increase in the average loan rate (or an effective rate of 9.65 percent). This incremental increase in the effective rate for the mortgage increases as the remaining principal decreases. When the remaining principal is $25,000, the effective loan rate is 9.8 percent; at $10,000 remaining, the effective rate is 10.25 percent. While this practice ensures there is a "pad" if interest rates increase, the practice is unnecessary and unwise when interest rates decrease. At this point in the loan, borrowers who are required to pay into a bank escrow account may be "encouraged" to refinance their mortgage sooner, provided the new lender allows them to pay their property taxes directly.
This concept becomes essential to the decision-making process when interest rates decline below the rate for any given mortgage. In the case of the original mortgage at 9. …