Monday, October 11, 2004

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Random thoughts on the housing market

The Chicago Tribune's Mary Umberger reports on the emergence of a new kind of mortgage:

When Jim Erbach set out earlier this year to refinance his mortgage, his credit union told him about a new loan that would cut his monthly payments by nearly $200.

"I'm cheap," said Erbach, who signed on for a 40-year mortgage.

He is also 73 years old.

"I have one objective in mind, to reduce the current costs of my expenses," explains the retired fleet manager who lives on a fixed income.

The Northwest Side man is in a pilot program to test consumer reaction to a relatively rare mortgage animal: the 40-year, fixed-rate loan. It's an experiment of 16 credit unions nationwide in partnership with Fannie Mae, which next year will decide whether to roll out the loans on a broad scale.

While a few banks offer the occasional 40-year fixed-rate mortgage, a stamp of approval from Fannie Mae could standardize such loans.

Officials at Fannie Mae and at Baxter Credit Union in Vernon Hills, which is participating in the test program, see the 40-year loans as a way to turn more Americans into homeowners.

Critics view the loans as creating more nightmares in a society saddled with debt.

"I thought the point of buying a home was to own it," said Amelia Tyagi, co-author of "The Two-Income Trap," an examination of American household debt. "With this thing, you pay until you die."

The basic concern of critics is that: a) this kind of mortgage saddles people with too much debt; and b) the lower per-month costs permits people who are genuinely bad credit risks to get credit, increasing nonperformance rates; and c) a secular increase in housing prices as demand increases.

My gut instinct is that these costs are far outweighed by the benefits of expanding the number of homeowners. Beyond expanding the investing class, this is particularly true if the introduction of this kind of mortgage instrument creates new neighborhoods of homeowners instead of renters. This is Mickey Kaus' territory, but I have to think that there are positive spillover effects from having a critical mass of homeowners in a neighborhood -- a greater investment in preserving social ties, an incentive to increase property values, and indirect feedback effects on education funding.

[But the example in the story is about an old guy buying a house.--ed. Yes, but this points to two other reasons why this is a good thing. First, it means that a lot of homeowners are rationally looking at their homes as financial assets that are currently outperforming other investments. Second, a 40-year mortgage would seem to be a rational response to an increase in lifespan.]

Of course, if we're currently experiencing a housing bubble, then expanding mortgages at this juncture would not be a good thing. But I am cheered by the IMF's recent World Economic Outlook, which includes an essay by Marco Terrones on the global housing boom. The basic conclusion of the piece is that, "The econometric results confirm that real house prices in industrial countries show high persistence, long-run reversion to fundamentals, and dependence on economic fundamentals." and that in the United States, the recent run-up in prices are consistent with this trend.

posted by Dan on 10.11.04 at 12:14 PM


My wife and I are in the middle of the home-buying process (offer out, waiting a response). We are both young (24 and 29). We've lined up a 40yr adjustable-rate with a 10yr interest-only option (actually, an 80% first mortgage with a higher interest 20% 2nd). This type of mortgage would seem to offer even greater concern to the opponents of a 40yr fixed, and for the same reasons.

As an aside, in our particular situation we will *not* be taking on too much debt, and offer very *little* risk to lenders.

posted by: wjc3 on 10.11.04 at 12:14 PM [permalink]

So the basic argument against this is that people with bad credit shouldnt be tempted to do something smart with their money because they probably wont be able to keep making good decisions? If the assumption is careless people will keep making careless decisions, whats the difference how they piss their money away? Shouldnt they be encouraged to at least take a wise chance?
As far as the length of the loan, pointless argument. Re-fi, my friends. Re-fi.

posted by: Mark Buehner on 10.11.04 at 12:14 PM [permalink]

I have trouble seeing the difference between a 40 year mortgage for the elderly and a reverse mortgage, which is supposedly ideal for the elderly. Why is one bad and the other good?

And in the "I have trouble" category, how can the long-term increase of housing prices exceed income increases and still be reverting to fundamentals? Feels bubbly to me.

posted by: Brian on 10.11.04 at 12:14 PM [permalink]

The fundamental problem with the criticism of the widespread use of the 40-year mortgage is that people are not smart enough to spend their own money properly. Sure, some people will get into way too much debt, just like they do now. The 40-year would give a lot more people a shot at home ownership, and I don't anyone who would argue with the social and economic benefits of that.

Plus, if I had a 40-year note, I could totally afford another gasoline-powered turtleneck sweater.

(come on, there aren't enough Steve Martin references in this world.)

posted by: Ashby on 10.11.04 at 12:14 PM [permalink]

Could someone explains what happens to the mortgage when the parties involved die? Does the bank foreclose? Do the children have the option of taking over the loan? Is the debt passed on to heirs, regardless of whether they want the debt?

posted by: Clark on 10.11.04 at 12:14 PM [permalink]

*I mean the assumption that people aren't smart enough is erroneous.


posted by: Ashby on 10.11.04 at 12:14 PM [permalink]

At one time 30 year mortgages were rare. With the 30yr becoming common the world did not end. Most people don't care if the mortgate gets paid off as long as they get a tax break and the house grows in value. I've never paid off a house but have made gains in the equity value of every home I've "owned." When all is said and done people move to a less expensive housing market upon retireing and buy their final residence with the profits from homes they never "owned."

posted by: Gorman on 10.11.04 at 12:14 PM [permalink]

Re: Clark's question. Each state has different laws regarding inheritence but usually who ever gets the property gets the mortgage and the equity value. You can sell it and pay off the mortgate and keep the difference. Remortgage it in your name or if it is worthless (more owed then it is worth) refuse the inheritence and let the owner of the mortgate deal with it. They will have a claim against the estate. Anyway it is a question for an attorney in your particular state to answer my view is just a laymans.

posted by: Gorman on 10.11.04 at 12:14 PM [permalink]

You will pay until you die is bad? Didn't Japan's financial markets allow for 100-year mortgages - on the premise that the kids will own the house and continue to pay. OK, I'm treading into Ricardian Equivalence territory a bit, but how does this increase the demand for housing. Of course the sheer stupidity of what Dan rightfully criticizes is echoed by those who think the cost of the Iraq War includes only what cash has been laid out so far (see pandagon on how his car cost only $622).

posted by: pgl on 10.11.04 at 12:14 PM [permalink]

It increases the demand for resident-owned housing because it brings down the monthly outlay required to purchase a house. This means a)more people are able to afford house payments instead of cheap rent (especially subsidized rent) and b)more people are credit-worthy for purchasing a house because the bank is forced to consider their monthly debt-income ratio differently. It's a simple extension of the premise that 30-year mortgages make houses more affordable than 15 or 20-year notes. People are leveraging their ability to make money over a longer period of time.
Of course, the real test for this is whether banks and other lenders are willing to assume that extra risk. They are, after all, laying out the same money to purchase the house, but they're getting it back at a slower rate. In the long term, though, they've made more money in interest.

posted by: Ashby on 10.11.04 at 12:14 PM [permalink]

First, I would like to see these kind of amortization tables apply to commercial real estate loans. If our investment properties could be carried with a 40 yr note, it would improve cash flows significantly. As to the issue of who pays the loan when you die, by definition, someone obtaining this loan will almost certainly be compelled to have a mortgage insurance policy with the note holder as beneficiary. Froggy

posted by: Froggy on 10.11.04 at 12:14 PM [permalink]

Even 30-year mortgages aren't expected to be paid off - the average family moves once every 3 to 5 years.

I once thought that a 100-year mortgage would give really small payments. It turns out that (as usual) the math is against you. As the term goes out and out, the payments get closer and closer to the interest-only amount, never smaller.

Even an interest-only mortgage is a bit strange. You buy a $200,000 house, pay on it or 20 years, after which you owe $200,000.

If you expect the value to go up, and you expect to sell it at that higher value, obviously, that's a good deal.

posted by: Mike on 10.11.04 at 12:14 PM [permalink]

This is outstanding! Why anyone would want to tie their cash up in a house is beyond me. It will appreciate at whatever rate it will appreciate at, regardless of how much equity you have. A mortgage is the cheapest cash you can find--get the longest possible mortgage for the largest possible amount.

Amusingly, I was thinking as I read this "boy, a 40-year interest-only mortgage would be ideal," then see that's exactly what wjc3 has lined up...("interest-only" mortages are generally interest-only for some period of time--3, 5, 10 years--and then higher payments kick in to amortize the principle by the end of the loan).

posted by: jsmith on 10.11.04 at 12:14 PM [permalink]

Run-up in housing prices? Wherefore are the housing prices up? I'm buying right this very minute in Austin, TX... where the value of a $200K house bought 2 years ago is now $180K. I'm only spending $125 for 2200 sq.ft., 3 blocks from a new elementary school. Granted, it's a foreclosure so that depresses the price a bit, but still.

High housing prices? Move to Texas, folks! The weather is better, and the people are nicer too.

(not to mention more people moving in will drive up the value of my new purchase... ;) )

posted by: Tony on 10.11.04 at 12:14 PM [permalink]

In a world that offers 72-month car payment options, I don't think this is out of line.

posted by: beloml on 10.11.04 at 12:14 PM [permalink]

A 40 year mortgage doesn't mean that the mortgage will be outstanding for 40 years. Implicit in mortgages is a 'free' pre-payment option that allows a mortgage owner to pay down principal beyond the monthly minimum. Since the average prepayment period of mortgages is not anywere near the term period the only thing a 40 year mortgage will do is reduce the monthly payment. The monthly payment affordability is a function of current income. Future income growth tends to allow for an increasing rate of prepayment.

Yes this will increase housing prices in the near term as demand for housing stock may increase faster than new housing stock can be built but this will only result in a secular increase in housing prices if some other factor limits housing stock growth such as the limitations of available land in already built up urban areas.

posted by: Brian in NYC on 10.11.04 at 12:14 PM [permalink]

either the borrowers can pay the mortgage or they can't. even in this booming market there have been very high foreclosure rates. putting people in houses that they can't afford, even at the most favorable terms, is not doing anybody a favor. the only reason lenders can make these loasn is they know fannie mae will buy them.

posted by: on 10.11.04 at 12:14 PM [permalink]

'the basic argument against this is that people with bad credit shouldnt be tempted to do something smart with their money because they probably wont be able to keep making good decisions'

No, the basic argument is that people who buy houses (glass or otherwise) should watch out for stones. 40 year mortgages represent a significant bet for consumers. If the housing market goes down (and even if it doesn't go down nationally, it could go down in different markets). If interest rates go up (and its hard to see them going down too much more), making refi harder. And so on

Now if people bankrupt themselves buying houses too expensive for themselves, thats their own headache in general. But the question is whether it points to an overheated market. I think it does.

posted by: erg on 10.11.04 at 12:14 PM [permalink]

Presumably the 40-year loan carries a higher rate than one of 30 years. As others have mentioned, even 30-year mortgages very seldom run to maturity. I think the average life is about 8-10 years.

So what we're seeing is higher rate and slower amortization being made available to people whose credit is not strong enough to justify the lower rate. Assuming the rate difference itself is not unreasonable, and that there are sensible down payment requirements, I see nothing particularly wrong with this.

The argument that "you pay until you die" from Ms. Tyagi is especially silly. If you rent you also pay until you die.

posted by: Bernard Yomtov on 10.11.04 at 12:14 PM [permalink]

As a point of clarification about interest-only notes, one can typically pay down the mortgage even during an interest-only period. My wife and I will be doing this very thing. The interest-only bit gives us some breathing room in the event we suffer a financial setback sometime in the next decade.

posted by: wjc3 on 10.11.04 at 12:14 PM [permalink]

Ashby - you may be right if households face borrowing constraints or if the Barro-Ricardian types are wrong about intergenerational bequests. But then you just made the case that the Bush tax cuts reduced national savings. Wait, they DID reduce national savings? Dr. Barro?

posted by: pgl on 10.11.04 at 12:14 PM [permalink]

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