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A Mortgage to Watch Out For

by Arnold Kling
article originally appeared on The Homebuyer's Fair August 10, 1994--has been updated since

Some large, reputable mortgage lenders have launched a new product, which they call the "asset-integrated mortgage" (more recently the "pledged-asset" mortgage.) If you use our Mortgage Analysis Worksheet to evaluate the new loan concept, you might conclude that it should be called the Asset Disintegrating Mortgage.

The new mortgage product works like this:

Suppose that you are buying a $100,000 house. You have enough money saved to cover closing costs, plus a $20,000 down payment. Ordinarily, you would put down $20,000 in cash and borrow $80,000. However, an alternative is to put down only $5,000 and borrow $95,000. This leaves you with $15,000 to invest. You might invest in bonds, mutual funds, or life insurance products.

Your balance sheet has the same net worth with either scenario, but you have more assets and liabilities with the $5,000 down payment. Here is the comparison:


                $20,000 down payment               
            assets           liabilities and net worth   

house      $100 K                                 
securities   $0
mortgage                              $80 K
net worth                             $20 K
Total      $100 K                    $100 K

                $5,000 down payment

house      $100 K
securities  $15 K
mortgage                              $95 K   
net worth                             $20 K
Total      $115 K                    $115 K


The "asset-integrated mortgage" adds a wrinkle to the $5,000 down payment scenario. Your $15,000 of securities are pledged as collateral on the mortgage. If you default on the mortgage, the lender is entitled to the $15,000 in addition to foreclosing on your house. This "pledged assets" feature increases the willingness of the lender to make the loan and also eliminates the need for you to obtain mortgage insurance.

Here is the way I saw this presented by one of the companies launching the program:


               ordinary mortgage      asset-integrated mortgage

down payment       $20,000                 $5,000
pledged assets        $0                  $15,000
loan amount        $80,000                $95,000
your assets
after 30 years        $0                  $90,000

Looks great, doesn't it? The problem is, the table compares apples and oranges. With the $95,000 loan, you will be making much bigger monthly payments. As we emphasize in our mortgage analysis worksheet, it is necessary to equalize the cash flows when comparing mortgages.

What happens to the analysis when we equalize the cash flows by making the same monthly payment with either mortgage? Let's assume that the mortgage rate is 8.5 percent, and that the rate of return on our assets is 0.5 percent per month, which compounds to just over 6 percent per year.

With the asset-integrated mortgage, we calculate the monthly payment on a 30-year, 8.5 percent mortgage for $95,000 to be $730.47 (see the mortgage calculator or the mortgage analysis worksheet.) To equalize the cash flows, assume we make this monthly payment on the ordinary mortgage, instead of the required payment of $615.13 on an $80,000 loan.

Using the worksheet, the monthly payment of $730.47 pays off the $80,000 loan in less than 20 years (212 months). With the mortgage paid off, we can invest the remaining monthly payments at 0.5 percent per month. Our assets start in month 212 at about $140, and each month our assets are the previous month's assets times (1.005), plus $730.47 in monthly payment. By the end of the 30-year term of the mortgage, we have $159,837.33!

Here is how I would summarize the comparison of the two mortgages using equal cash flows:



          ordinary mortgage      asset-integrated mortgage
          with higher payments

down payment   $20,000               $5,000
pledged assets    $0                $15,000
monthly payment   $730.47              $730.47
month loan 
  paid off        212                  360
assets after 
  30 years    $159,837.33           $90,338.63

If you can afford the higher monthly payment needed for the asset-integrated mortgage, then you are better off making a 20 percent down payment and obtaining an ordinary mortgage. In fact, you could take out a 15-year or 20-year mortgage at a lower interest rate and do better still.

Intuitively, the asset-integrated mortgage has you borrow more money at 8-1/2 percent in order to re-invest at 6 percent. This is a losing proposition that will cause your assets to disintegrate.

Does that mean that the asset-integrated mortgage is always a poor choice? No. I can conceive of circumstances where it might make sense. For example, if you have assets with large embedded capital gains, then you may be able to defer paying taxes on those capital gains by pledging them instead of liquidating them. Check with your tax lawyer first.

There may be other tax angles to play if the assets are linked to life insurance. However, insurance company overhead eats away at a lot of the tax advantages, and I personally have never been impressed with life insurance as an investment (I stick with basic term life insurance).

In conclusion, I believe that the deceptive marketing of this mortgage product reinforces some points made in the mortgage analysis worksheet.

Please use the comment form in the checkout counter to comment on this article. Was the analysis clear? Do you believe it to be correct?

March 1996 update

Like old wine in a new crock, this mortgage keeps coming back. The newest version is the "pledged-asset mortgage," in which the asset must be a bank certificate of deposit. You obtain a larger mortgage of, say, 7 percent, so that you invest in a CD that pays, say, 4 percent, with the CD pledged as collateral against the mortgage. Certainly a good deal--for the bank!

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