Policies directed toward encouraging home ownership by increasing the affordability of mortgages usually reduce the rate at which borrowers build equity in their homes. The simplest illustration of the conflict in objectives is the difference between a 30-year and a 15-year home mortgage.
Earlier this month, a 30-year mortgage for $100,000 at 4.25 percent had a monthly payment of $492, while a 15-year mortgage at 3.375 percent had a payment of $709 — 44 percent higher. After five years, however, the amount owed on the 15-year had been reduced by $27,900 compared with a reduction of $9,192 on the 30-year. Home equity growth on the 15-year is three times as large.
Since World War II, public policy has prioritized affordability over equity growth. This affordability bias reached its peak in the years leading up to the financial crisis. That period saw the emergence of interest-only provisions tacked on to the first five or 10 years of 30-year mortgages, which meant that for five or 10 years, there was no paying down the loan balance at all.
Option ARMs went even further, allowing borrowers to make payments that didn’t fully cover the interest, which resulted in an increase in the loan balance — called “negative amortization.” These instruments are gone and good riddance, but the conflict between affordability and equity growth remains.
The reason is the United States is moving into a retirement-funds crisis as net worth at retirement declines and life expectancy rises. Home equity is a potential buffer against economic hardship after retirement. This shift in priorities raises the critical question of how to create an incentive for homeowners to build equity more quickly, if possible without reducing affordability. As an important example, we would like to see more home buyers finance their purchase with a 15-year mortgage rather than a 30, without eliminating the 30 as an option for those who really need it.
One simple way to encourage home equity growth is to amend the tax code so that principal payments, rather than interest payments, are deductible. The existing system encourages debt, when we should be encouraging debt repayment. It would be plausible to provide a larger deduction for extra payments than for contractually required amortization payments.
We should also make it easier for homeowners to develop extra payment programs as part of their household budgets. I have developed five mortgage payoff calculators that provide a variety of ways to design and monitor extra payment programs. These calculators are freely available on my website (www.mtgprofessor.com), but such facilities are not available on official sites — those of Fannie Mae, Freddie Mac and their regulator the Federal Housing Finance Agency — where they would have a much greater impact. I would be pleased to license my calculators to any or all of those agencies at no charge.
But by far the greatest challenge to a federal effort to encourage equity growth is a widespread belief that home equity is what you leave to your estate, which is not a great motivator. Since 1990, the federally sponsored HECM reverse mortgage program has been available to convert home equity into spendable funds without jeopardizing the owner’s right to live in the house indefinitely. But the program is not widely understood and is viewed with suspicion. Fewer than a million HECMs have been written in total since the program began, and the current annual rate is only about 60,000. As a point of comparison, about a million homeowners retire every year. Priority one for dealing with the retirement funds crisis is to bring the HECM program to life.
Dysfunction in the HECM market rivals that in the medical services market. Confusion on the part of seniors about how HECMs work is widespread — they are very different from the mortgages with which they purchased their homes. The product at issue is obscure because seniors often do not know how they want to receive money under the HECM — whether as upfront cash, monthly payments, credit line, or a combination. Further, there is no way for borrowers to compare the deal offered by one lender with the deal offered by another, and very few try.
I call it a “gotcha market” because lenders seek to attract potential borrowers into making contact, then collecting the information needed to entangle the prospect in a process that encourages them to take a HECM but discourages them from looking elsewhere. Borrowers may exit the process because they get cold feet, but they don’t exit to get a better deal elsewhere.
The HECM market is unique in mandating that all borrowers be counseled before they commit to a lender, but counselors are not part of the market mechanism. HUD states, “The job of the counselor is not to steer or direct you toward a specific solution, a specific product, or a specific lender.” The purpose seems to be to prevent sins of commission by assuring that borrowers are not committing themselves based on erroneous beliefs, or on failure to consider alternatives. That’s OK, but it ignores the much more important sin of omission, where seniors who need help don’t consider reverse mortgages because of unwarranted fears, ignorance or erroneous beliefs. These seniors never see a counselor.
The key to bringing the HECM program to life is in converting the dysfunctional market into a shoppers market with three central features:
A credible source of basic information on HECMs for seniors exploring the concept.
A credible source of current transactional information on available draw amounts, for seniors who want to try out the concept without contacting a lender.
Credible sources of current pricing information from multiple lenders that allows shoppers to select the lender whose HECM provides the best value of the particular metric in which the borrower is interested.
When the cause of market dysfunction is either excessive market power or neglect of important externalities, we look to regulatory agencies for a fix. But when the cause is ignorance and misinformation in the face of product complexity, and the product is insured, we should look to the insurer for a fix because market dysfunction raises insurance costs.
This is the case with HECMs, where FHA insures lenders against loss and borrowers against lender default. The information required to implement the three components of a shoppers market are readily available to HUD/FHA at no cost.
Jack M. Guttentag is retired professor of finance at the Wharton School of the University of Pennsylvania. www.mtgprofessor.com