How do you encourage home ownership without repeating the mistakes of the current subprime mortgage market bust?
One fundamental flaw that caused the subprime mortgage collapse was over-optimistic loan underwriting. In other words, lenders agreed to loan money to people on terms that it was unrealistic to believe that they would be able to pay in the long term. Some of the related common sins (short of actually dishonest ones like appraisal fraud and kickbacks) were:
* Low down payment loans. Low down payments increase the risk to the lender and reduce the incentive of the borrower to find a way out of default such as selling the home or refinancing. They also show that the borrower has a poor history of saving.
* Pre-payment penalties. These prevent borrowers from getting a better deal when they learn that they can't handle their current deal, or have proven their better than anticipated credit by making regular payments.
* Adjustable interest rates. These take a payment that was affordable and increase that payment if interest rates go up after a certain time period (or often even if they don't in "teaser rate" loans).
* Negative equity, interest only, and very long amortization period loans. These types of loans all prevent equity building. A negative equity loan increases your debt during a teaser period, which is only offset in booming real estate markets at risk of subsequent bubble collapses. An interest only loan creates equity only from rising housing prices. A very long amortization period loan (e.g. 40 and 50 year loans) reduce principal payments but not quite to zero.
* Weak verification of earnings. Lenders assumed that current incomes would be there forever, increase and remain uninterrupted, an unreasonable assumption for working class and middle class workers in a rough economic moment.
* High interest rates and private mortgage insurance payments. Borrowers most at risk of not being able to make their payments are given the msot difficult to make payments of all through high interest rates and the requirement that they purchase private mortgage insurance for the benefit of the lender at their expense.
Suppose that you aren't all about short term profits for a mortgage company, and instead want to increase home ownership rates, decrease default rates, and encourage wealth accumulation. How would you design loan terms then? In other words, would kind of loan would you write for you financially struggling nephew or grandchild? I think you might consider something like what I will call an "equity builder loan." These would have the following terms:
* Fixed interest rates similar to those available for conventional mortgage loans.
* No private mortgage insurance requirement.
* No pre-payment penalties. Indeed, borrowers would be receive communications encouraging them to refinance at the actually transaction costs to the lender if interest rates fell, from the same lender.
* Higher up front "equity account" payments. Borrowers would be required to pay bigger payments than a 30 year amortization (perhaps the amount due under a 15 year amortization) until the down payment plus principal payments were equal to 20% of the purchase price of the property, typically about three and a half years with a 5% down payment or about two years with a 10% down payment. The excess over principal and interest, taxes and insurance would be credited to an equity account which would have the same effect on interest amortization under the loan as additional principal payments in a conventional loan. After the initial period, the excess payment would be optional but would not be changed without an affirmative request to lower it.
The initial up front payments, on the order of $400-$500 a month in a purchase of a $150,000 house for the first few years, would be comparable to the premium over a conventional loan paid for private mortgage insurance and the higher interest rates typical in a subprime loan. But, unlike a subprime loan, the additional payments would benefit the borrower, and not the lender, if payments were made as agreed.
* Low but not zero down payments. Down payments lower than those for other kinds of loans, but never zero (probably a minimum of 5% down with sufficiently good credit) would be allowed, because high early payments on the loan would build equity in the residence to more conventional levels in the first few years when borrower income and circumstances are most predictable. The minimum down payment would show at least some demonstrated ability to accumulate cash and get a few paychecks ahead.
* Stricter underwriting. Lender ability to pay would be based on the initial higher payment, rather than the long term minimum payment, using criteria apart from downpayment similar to those applied to a conventional 30 year fixed rate loan with that monthly payment. Thus, equity builder loan borrowers would have to finance a lower priced home relative to their income than a conventional borrower.
* Equity account funded grace periods. A missed payment would trigger mandatory (free of charge) credit counseling, but would not result in a default authorizing a foreclosure or a credit rating hit until the accumulated interest, late fees and other non-principal amounts owed exceeded the "equity account" on the loan. This would forestall debtor paralysis while preventing a borrower with a good payment history who is facing a slight hiccup from seeing their situation snow ball out of control.
* Low late fees (e.g. $10, rather than 5% of a monthly payment) and no default interest rates. The goal would not to make a bad situation snowball into something worse, making it possible to recover from a missed payment.
* A sell back option. Financially stressed borrowers would have a right to sell their homes to the lender for 90% of appraised value as determined by an appraiser selected by the lender, at borrower expense plus a modest processing fee (perhaps $100-$200), even in the absence of a default and in any case at any time prior to a foreclosure sale. Exercise of the option itself would not be reported as a default on credit reports. The lender would apply the proceeds dollar for dollar against the amount owed on the loan. Any surplus would be promptly paid to the borrower. Any deficiency would automatically be financed by the lender on terms comparable to those available from a credit card company for a borrower in good standing (e.g. 1.5% interest per month and a minimum payment of 4% of the outstanding balance). This would provide a framework to allow the borrower and the lender to extricate themselves from loans about to go bad with minimal time and dead weight transaction cost losses. Debtors who had just lost jobs, for example, might promptly exercise this option so they could downsize, without losing time and money to hiring real estate agents or trying to refinance the loan.
* Small loans. The loans might be made available for properties selling for not more than 150% or 200% of the median or average single family house value in the area and no cash back would be allowed. This would limit the room for losses from appraisal frauds and keep the program focused on the target social objective.
The lender would be a government agency, non-profit or mutual company. It would partner with an unsubsidized non-profit or for profit building company to develop affordable housing which would be financed with equity builder loans.
This might very well not be profitable. But, it would be at least very close to a break even operation and I suspect that the subsidy could be quite modest, relative to the benefit created. I would expect default rates that while probably no better than conventional loans, would be much better than those on subprime loans entered into by comparably credit worthy people.