For more than 50 years, U.S. housing policy has relied on looser and looser mortgage lending standards to promote broader homeownership and accomplish wealth accumulation, particularly for low- and middle-income households. This effort has achieved neither goal due to two flaws: First, it fosters unsustainable lending by piling heavy debt burdens onto households with limited financial resources. Second, by relying on 30-year loans with small down payments, homeowners build equity very slowly, giving them little protection against life’s vicissitudes and volatile home prices.
As a result, our homeownership rate is no higher today than it was in the early 1960s, with millions losing their homes as a result of a misguided affordable housing policy implemented in the 1990s, which encouraged aspiring home buyers to buy homes they could not afford. Further, the goal of building wealth for low- and moderate-income households has not been achieved. According to the Federal Reserve’s Survey of Consumer Finances, households in the 20th to 40th percentile of the income distribution — a prime target for homeownership according to federal policy — had a median net worth of only $22,400 in 2013, the lowest inflation-adjusted amount in any of the Fed surveys dating back to 1989.
This is precisely what happened during the 1995 to 2006 unsustainable boom in real home prices. Loan amounts were constantly increased during this long-running seller’s market. Even now, history may be repeating itself as we have had three years of rising real home prices driven again by liberalized credit terms undertaken in a seller’s market. Increasing the amount that can be borrowed allows home prices to increase more rapidly than incomes, thereby moving the goalpost further away for many aspiring low- and middle-income homebuyers.
For most low- and middle-income families, the path to reliable wealth building is to buy a home with a wealth building mortgage, invest in a defined contribution retirement plan (ideally with an employer match), and invest in education.
A housing finance system prepared to meet the needs of twenty-first century Americans is an integral part of the wealth building recipe. Three steps would help create such a system.
First, housing finance needs to be refocused on the twin goals of sustainable lending and wealth building. The new Wealth Building Home Loan (WBHL) that Stephen Oliner and I developed does exactly that. It offers a much safer and secure path to homeownership and financial security than the slowly amortizing 30-year mortgage.
o The WBHL can have either a 15-year or a 20-year term. In either case, borrowers accumulate home equity quickly, in effect making sizable contributions to a “home savings account” every month. The interest rate on the WBHL can be fixed for the life of the loan or can adjust after a minimum of five years provided that the payment increase at the time of adjustment is modest. This option gives lenders the flexibility to design loan products that limit their interest-rate risk and simultaneously lower the initial monthly payments for borrowers.
o The WBHL requires little or no down payment. Even with no money down, the 15-year WBHL generates more equity within two years than a 30-year mortgage with five percent down, and the 20-year version does so in less than three years.
o Borrower funds that would normally go for a down payment are instead used to buy down the interest rate on the WBHL. The rate buydown serves several purposes: it lowers the monthly payments somewhat; it reduces the likelihood that the loan would be refinanced, which is attractive to lenders and investors looking for a stable payment stream; and it should contribute to neighborhood stability, as borrowers reap the benefit of the lower interest rate only by staying in the home for at least five years.
Second, the home mortgage interest deduction should be restructured to provide a broad, straight path to debt-free homeownership. Today’s tax code promotes a lifetime of indebtedness by incenting homeowners to take out large loans for lengthy terms so as to “maximize the value” of the deduction. Reorienting this deduction towards reliable wealth building and debt extinguishment would have an important added benefit. Once borrowers pay off the mortgage, the monthly cash flow previously used to service the debt becomes available for two other life-cycle savings challenges: planning for a child’s post-secondary education and making added contributions to defined contribution retirement plans.
o For future homebuyers, change current law to cap the interest deduction to the amount payable on a loan with a 20-year amortization term. Exempting existing homeowners and providing a substantial phase-in period would ameliorate the impact of the change on current home prices.
o Future first-time homebuyers with incomes below 80 percent of the metro area median income would have an option to forego the interest deduction and instead receive a one-time refundable tax credit to fund up to eight discount points when used to buy down the loan’s interest rate for at least 5 years. The credit would be available only for loans with an initial term of 20 years or less.
Third, modify the qualified mortgage rule to encourage wealth building.
o Raise the current 43 percent limit on the total-debt-to-income ratio to 45 percent for loans with a term of 20 years or less, in recognition that a substantial portion of each monthly payment is principle amortization and is actually savings.
o The limit could be raised further for borrowers who take out such loans and are also accumulating savings with an employer-provided pension plan.
This wealth building approach provides a broad, straight path to debt-free home ownership, education for one’s children, and a comfortable retirement.
Pinto, a former chief credit officer of Fannie Mae, is the co-director and chief risk officer of the International Center on Housing Risk at the American Enterprise Institute.