Structural Problem with our Mortgage-based Home-ownership System

Unfortunately, as long as US homes are largely purchased with 30-year mortgages, we are going to see large price swings for houses as interest rates swing, and bail-outs are likely every time interest rates go up unless it goes up very slowly and inflation goes up to match.   This is a structural problem that is going to be difficult to avoid, since many institutions are dependent on this system including millions of voters.   At least understanding how this happens can help motivate looking for alternative systems, such as debt-free housing.

The structural problem stems from people buying as much house as they can afford, and how much house they can afford is based on the monthly payment. (http://www.bis.org/publ/qtrpdf/r_qt0403f.pdf)   I do not believe this is because people are greedy, but rather that competitive pressures cause the housing prices to rise to meet the market.    That is to say, if the majority of people were not willing to pay a particular amount, then the housing prices would change to reflect this.   This would not change the housing stock, it would just change the price it would sell for.   The above cited study shows that people are willing to pay what is determined by the percentage of income allowed by government mortgage guarantee programs (Fannie Mae and Freddie Mac).

“The 30-year loan first became broadly available by an act of Congress in 1954 and, from then until now, the vast majority of such loans have been issued only with government support.” https://www.nytimes.com/2011/03/04/business/04housing.html?pagewanted=2&_r=1&partner=rss&emc=rss

If this government support program were to disappear, then housing prices would fall since banks are unlikely to give more favorable terms, or they would be giving them already.   Since so many people and institutions would suffer with a general fall in housing prices, it will be politically difficult to take away this program.

The next step is that given a monthly mortgage rate, the price of the house is a straight calculation based on the interest rate—for a given monthly payment, the lower the interest rate, the higher the price.   Monthly payments are based on salaries, since there is a formula that the federal mortgage guarantee entities use to calculate this. (http://www.census.gov/hhes/www/housing/special-topics/files/who-can-afford.pdf)

The price is largely set by the monthly mortgage that people in the area can afford, rather than the worth of the house.   In the 70′s and 80′s in the United States the mortgage payments were set at a maximum of 28-29% of income to be guaranteed by the government.     These regulations were loosened during the 2000’s which helped create the housing bubble thus the bail-outs and foreclosure boom that is going on now. But interest rates are at historic lows, with government guaranteed 30-year fixed mortgages at less than 5% interest.   When this interest rate raises, then either housing prices will fall or monthly payments will have to rise.   Monthly payments are based on salaries, which in turn are changed based on inflation.    Housing prices falling will cause more foreclosures because more houses will have an outstanding mortgage for more than they are worth, and mortgage holders will not be able to move out of a house based on selling it, so will have to foreclose if they want to move or can not afford the monthly payment for some reason.

Will inflation raise salaries enough to compensate for a raise in interest rates?  It does not appear so, unless interest rates rise very slowly.    A $250,000 dollar loan at 4% interest costs $1200 per month, yet if the interest rate went up to 10%, then the cost would be over $2,100 per month.  The salary would have to double to afford this increase.  Doubling based on 7% inflation would take 9 years (see below).    So as interest rates increase, inflating salaries will likely lag, thus causing a downward pressure on housing prices.

With 30-year mortgages, the fluctuations in interest rates will likely cause housing prices to fluctuate more than inflation can even out.   Housing price decreases cause foreclosures, and enough foreclosures cause bank failures or bail-outs.    Debt-free housing avoids this, but that is the subject of other posts.

Option 1 Option 2
Loan amount $250,000 $250,000
Interest 4% 10%
30 year-fixed 30 30
Monthly bill ($1,193.54) ($2,193.93)
fannie regulation 29% 29%
min yearly salary $49,388 $90,783
inflation estimates 1% 7%
years to inflate salary 7% $90,797
years: 9

 

 

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6 Responses to Structural Problem with our Mortgage-based Home-ownership System

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  3. Al Broadman says:

    I understood every world you wrote and while all of what you have written is true, I have to say there are better ways of doing things and have to disagree with at least one of your conclusions.

    “If this government support program were to disappear, then housing prices would fall since banks are unlikely to give more favorable terms, or they would be giving them already. Since so many people and institutions would suffer with a general fall in housing prices, it will be politically difficult to take away this program.”

    Few people started out with the idea that their home was an investment. This concept was placed in their heads in an attempt to justify, legitimize, and move housing away from a necessity to an investment vehicle. Until recently, the majority of people did not see their homes as an investment, rather they seen them as necessary and a place to hang their hats. That state of mind kept housing prices pretty stable and linked mostly to resource inflationary pressures.

    Once housing started being seen as an investment, then our society’s focus shifted from housing our population to building personal wealth through our residences with various forms of financial trickery. This drive for personal wealth drove housing inflation rates at an amazing speed and its a wonder it lasted as long as it did.

    As housing costs begin to outpace wage increases, this stealth life tax created though the most innocent of means ( wanting to improve your financial future is not inherently a bad thing ) fewer people could really afford the homes they had purchased if they had the misfortune of only being able to acquire a variable rate mortgage. (which is what most people have)

    Because of financial pressures outside of themselves, many people have found themselves owing more than their homes were really worth. Many seem to think this is their own fault and they are partially correct, but we should not fail to recognize the so called banking and real estate experts who avowed to their dying breath that this was the best way of doing things.

    We do need to change something in regard to housing in this nation. People need to become used to the idea again that a home is a place to live, not a future piggy bank. The only reason you should see your home as a future source of income is if you choose to move elsewhere. National policy should reflect this understanding as well and move away from policies that encourage housing price inflation to sure beyond what is known to be necessary because of resource inflation.

    In essence, you are correct there are structural problems with our mortgage system and the problem stems from viewing housing as an investment vehicle rather than as an essential aspect of maintaining an advanced society who benefits from everyone being able to afford good housing without suffering lose of quality of life in other aspects in order to be able to afford a mortgage.

    Individuals will not suffer from this change in policy, however institutions will. Considering some of the dubious behaviors of this industry, I find myself having little sympathy with them if they had to take a serious haircut. The nation as a whole would benefit from drastically decreased housing prices due to the increased number of people able to afford housing and become stable members of their communities.

    As you can see, I have taken quite a leap into elements of socioeconomics concerning this problem and feel that core needs by members of society should be provided at the lowest costs possible and not seen as a means to profit. Any profit derived from satisfying the needs of our society take away from the quality of life our society enjoys and robs wealth from the hands of the majority of society allowing it to be concentrated into every smaller numbers of hands which gives those institutions the ability to manipulate our economic quality of life even more so than it already is.

    Globalization of the workforce and increasing trade treaties will cause wage stagnation for the first world for the foreseeable future and any type of resource inflation will result in loss of quality of life for everyone involved in this growing economic mess we have created. Home prices need to deprecate quite a bit more than they already have, if the new norm for the majority are service based jobs that pay less than double of the federal minimum wage, if we expect individuals to be able to maintain their quality of life and achieve some sort of financial security.

    Very complex issues here but the heart of the matter is who is going to benefit and who is going to lose with this concept. Do we find it acceptable that the wants of the few outweigh the wants of the many? I personally do not, and find it amazing that so many people advocate policies that go against their best interest in the hopes they they too will be one of the few one day who are considered the Elite.

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  6. Tom Kerr says:

    “Will inflation raise salaries enough to compensate for a raise in interest rates? It does not appear so, unless interest rates rise very slowly.”

    Interest rates look poised to stay quite low, but given the dollar’s comeback from its july low, inflation will remain weak as well, as this stifles exports. Also, taking into account recent data showing falling hourly wages and the fact that for much of the country the housing bubble is still deflating (prices are on average 10% above trend) one should not expect much improvement anytime soon.

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