The Low Income Homeowner Problem
In my post on the State Economic Freedom Index
yesterday, I noted that Colorado has a record high foreclosure rate and that a quarter of the people in the state can't pay their utility bills (not for the first time on this blog).
An anonymous commentator to that post (I have my suspicions, but the argument speaks for itself) took me to task for failing "to connect the dots in your previous attack (A Cause Worth Fighting For?)
on low-income homeowners, who offend your delicate sensibilities by having ugly houses they can't afford repair."
Am I a hypocrite? I think not. And the reason that I'm not, while it takes a while to set forth, is worth exploring.
An abundance of unrepaired homes in Boulder, late utility bills, and high foreclosure rates are all symptoms of the same problem. We have many homeowners who can't really afford to own the homes that they are in.
While it seems harsh, in many cases the real solution is not to cut them extraordinary slack from the forces that threatened their continued home ownership. Banks can't pay depositors or continue to loan money if loan payments aren't made (banks are extremely leveraged organizations with surprisingly low asset to equity ratios). The natural gas and electricity can't continue to serve homes if the utility companies can't maintain the cash flow needed to buy coal and natural gas from third party suppliers at market rates. Broken windows and unrepaired garage doors, along with other kinds of disrepair are bad for neighborhoods and not what homeowners would want for themselves either.Home Ownership Is Overrated
Home ownership is overrated. Right now, given the nature of our economy, too many people own homes. Not everyone should own a home, and one of the main sources of Colorado's woes of stretched low-income homeowners is that we have many people in this state who were unwisely encouraged to become homeowners.
Simply maximizing home ownership is bad policy, and we are finally starting to realize that now that homeownership rates are at near record highs
The home ownership rate for 2005 was 68.9%, down slightly from the recent high of 69.0% recorded in 2004. The 2004 rate was the highest rate since the Census Bureau began reporting these statistics in 1965.
Incidentally, homeownership was lower for almost all of the period before 1965, because until the GI Bill, Fannie Mae and Freddie Mac made mortgages with long amortization periods available at reasonable rates, home ownership was far more difficult to achieve. But, the changes wrought by those innovations were more appropriate than the steps we see today. Those institutions largely were important because they created secondary markets that allowed lenders with only modest funds of their own, to provide mortgages to credit worthy people in transactions structured to be extremely safe for any lender. More recent innovations have created homeownership options for low income, low asset, bad credit families who are ill served by owning homes.The Economics of Home Ownership
What are the differences between home ownership and renting?
Increasingly, so called home ownership looks a lot like renting. Only a small minority of households own their homes free and clear. Most households either rent or have a mortgage. Either way, one must make a hefty monthly payment to a third party to keep a roof over your head. But, the risks and costs associated with the two different ways of providing shelter for a family are materially different.Renting
Most of us are familiar with the typical residential lease. Typically, the tenant pays a fixed monthly rent in exchange for possession of an apartment or house. Typically in a residential lease, the landlord is responsible for paying property taxes on the premises, maintaining homeowner's insurance on the structure, paying the mortgage, if any, on the premises, and making major mechanical or structural repairs for problems not due to tenant negligence.
Some leases are month to month, one or two year leases are common, and residential leases as long as five years are not unheard of, but rare. Beyond the terms of the lease, there is typically no protection against rent increases and the expectation is that if the rent increases that the tenants will move.
The tenant's security deposit is typically in the vicinity of one or two months rent, and typically is returned at the end of the tenancy with some deductions for damages to the premises, within a couple of months of the tenant's departure, if the rent is current. Any appreciation in the property, or depreciation in the property to due to changing real estate market, accrue to the landlord.
If rent is not paid as agreed, the eviction process takes a month or two, the security deposit is lost, and the tenant may end up subject to a judgment against him or her for a moderate amount of attorneys' fees and unpaid rent. Generally speaking, a tenant unable to pay the rent who can locate a subtenant can avoid all or most of the liability associated with the balance of the lease obligation. Often, a landlord will seize the entire security deposit and not bother suing if the tenant leaves voluntarily, as landlords know that usually the tenant misses rent payments because he or she is unable to pay and uncollectable in the near future, and the amount owed is typically modest compared to the costs of collection.Owning
If you own a home, you typically make a down payment on the house and borrow the balance with what is commonly called a mortgage (in Colorado, the proper name is a deed of trust in almost all commercial transactions). The down payment for first time home buyers usually ranges from 0% to 25%. If the down payment is less than 20%, the mortgage is "non-conventional" and the home owners must pay, in addition to a mortgage payment, "mortgage insurance" which reflects the extra risk the lender is undertaking in a low down payment loan.
Typically, a first time home owner will pay property taxes and homeowner's insurance through an escrow whose monthly payment is included with the mortgage payment and mortgage insurance if any.
Maintenance is the homeowner's responsibility, and while the right is rarely enforced, failure to maintain the property is typically a ground for default under the mortgage, even if the payments are current. Almost no mortgages set aside an escrow or require insurance for maintenance issues. Typically, people assume that owned homes are better maintained than rented homes, and on average they are. This is because owners have a better chance of recovering their repairs than tenants, while landlords have a hard time knowing that their properties will be treated well by tenants and knowing what needs to be fixed. But, the other part of this perception is that traditionally, home owners have been affluent enough to keep their homes in good repair. An landlord is usually better able to make repairs than a low income homeowner with no little or no savings, and only de minimus equity.
A mortgage is generally amortized over a long time period. The norm is 30 years. Shorter term mortgages are available, by first time buyers almost never get a mortgage for a term of less than fifteen years, and mortgages of that length are uncommon. It is now possible to get a loan amortized over as long as 50 years.
Except in the case of reverse mortgage (typically marketed to long time, elderly homeowners with ample equity and inadequate retirement savings), monthly payments cover all current interest due (so interest is not paid on interest) and the amortized share of the principal payment, which very small at first, and the bulk of the payment at the end of the amortization period, in addition to mortgage insurance, and the escrow payment for property taxes and homeowner's insurance. A significant proportion of new mortgage loans are "interest only" with a balloon payment scheduled after a long mortgage term at which point the owner is expected to refinance, to have paid off the principal sooner than required, or sell the property.
Interest rates are a function of the owner's credit, the amount of the down payment, the term of the loan, and whether to interest rate is fixed, variable or a hybrid. A homeowner with excellent credit, a down payment of at least 20%, a 15 year term, and a variable interest rate pays the lowest interest rates of any kind of loan available to anyone. A homeowner with bad credit and a small down payment must pay "subprime rates" which are often only marginally better than financing a home with credit cards.
Homeowners with good credit frequently choose to pay the modest premium associated with a fixed rate. Homeowners who are stretched often get variable interest rates or hybrid interest rates that cause payments to rise (or fall) when interest rates do, in exchange for a smaller initial payment, and an amortization period of at least 30 years.
Loan eligibility is typically governed by a ratio of payments to income. The smaller the payment, by hook or by crook, the more the home owner will be permitted to borrow.
Foreclosures are overwhelmingly concentrated among subprime loans, loans with small down payments and loans where a variable rate or hybrid loan rate increase has caused payments to increase significantly.
Outside of Colorado, almost all mortgages are full recourse loans. This means that if the house appreciates, the benefit goes to the homeowner, but if the house gets "upside down" because the amount owed on the loan is more than it is worth, the homeowner owes the difference if the house is foreclosed upon.
The foreclosure process takes a long time, typically in excess of six months, and if the owner doesn't leave voluntarily, must be followed by an eviction. Selling a house can take a long time as well, often three to six months or more, and usually takes longer in the bad markets when foreclosures are common, than in the good markets when foreclosures are rare. Often securing a quick sale means selling for less than a fair market value price.
Except in the rare cases when a foreclosed upon house has so much equity that it provokes competitive bidding (and metropolitan Denver has a healthy foreclosure market so this does occasionally happen), the bank typically bids the amount of its loan at the foreclosure sale and the owner ends up losing all of his equity if he has any, and owing money to the bank, if the amount of the loan, including typically many months of very high default interest rates and late fees, plus the substantial collection costs associated with the foreclosure, substantially exceed the fair market value of the property.
Also, even when foreclosure is avoided by a home sale, typically more than 7% of the fair market value of the house or more, which may exceed a first time home buyer's equity in the house, may be lost to realtors' commissions, closing costs and repairs that have to be made to make the house marketable.
The ability to avoid foreclosure by selling is also complicated by the psychological reality that while renters are often resigned to moving on if they can't make the rent, that home owners, even when they clearly can't afford their homes, often hang on until the biter end refusing to give up a home that they own, often the only major purchase they have ever made in their lives. In part this is the "my home is my castle" philosophy, and in part this is a perceived loss of socio-economic class as one moves from being a home owners to a renter.Why Rent?
Why would someone want to rent? The basic reasons are the allocation of risk, financing terms and financial ability.
If a prospective home owner doesn't have the cash on hand for a 20% down payment (plus a little extra for closing costs and a little cash on hand as a modest emergency fund), and good credit, the financing costs associated with being a homeowner are quite high.
Suppose you are buying a $250,000 house (which is a low end starter home in metropolitan Denver). If you can pay $50,000 down and have good credit, you can probably get a $200,000 loan at a fixed rate, for a 30 year term with a 6.5% interest rate. Thus, you are paying $13,000 a year to the bank to live in your home (in addition to property taxes, insurance, maintenance and paying back the principal).
In contrast, if you have bad credit and can only afford to put 5% down on the same house, you will probably pay a 10% interest rate, may only be able to have the rate fixed for three years after which it floats based on some interest rate index (and interest rates are still historically low), and will also have to pay mortgage insurance which could easily be $100 a month or more. Thus, your loan amount may be $212,500, your annual interest payment including mortgage insurance may be $22,450 per year, and in addition to this, you face the real risk that your interest payment will go up in a few years, increasing the cost of home ownership even further.
The market reality is that landlords to not pass on the difference between the good credit rating conventional financing they can obtain, and what it would cost for a tenant to finance a home to the tenant. Indeed, in times when housing prices are in an inflated bubble, monthly rents are typically less than what a landlord with good credit needs simply to cover good credit financing at current market rates and the costs of ownership -- because many landlords see their main source of profit as appreciation in the value of the property itself, and have relatively low financing costs because they financed their purchase for a smaller principal amount when home prices were lower.
Encouraging moderate to low income families with little cash and bad credit to pay a $10,000 a year plus premium over what their landlord can obtain for the privilege of having a residence that is harder to get out of the family's income is disrupted or a maintenance problem or increased utility bills disrupt their ability, and more costly to the family in the event that a substitute occupant of the premises cannot be found, is a no deal to that low income family.
Indeed, the low income family often cannot receive as much of a tax benefit from having tax deductible mortgage and property tax payments, because they are in lower tax brackets than middle class families that qualify for conventional financing. And, they tend to have less stable employment, which is a big concern when you are making a loan that must be paid every single month, on time, if you remain in your home.
For most families who don't qualify for a prime rate loan or don't have enough of a cash cushion to make payments without fail in the event of a maintenance emergency or brief period of unemployment, and for many families who can't afford a full 20% down payment in addition to that emergency fund, buying a home is a bad idea fraught with risk and likely more expensive than renting.
This advice is mitigated in the case of low down payment purchased made when housing prices are soaring, because hot real estate markets create equity, reducing the downside risk of not being able to make payments and having to sell the home, possibly at a loss, but it still rarely makes sense to buy a home when you are paying subprime interest rates and could be renting from someone who isn't paying those rates, particularly because rents tend to be particularly low during hot real estate markets.
At times like the present in Colorado, where the real estate bubble is deflating through stagnate real estate appreciation, the general rule that home ownership really only makes sense for those able to get good financing terms and have a decent financial cushion makes sense. Conclusion
Many of the economic woes we are seeing right now in the Colorado economy are a product of low income families buying homes they can't really afford. Many were lured into buying houses with subprime loans, low down payments accompanied by mortgage insurance payments, interest only loans, and variable interest rates that have caused monthly payments to surge as interest rates have risen from their previous historic lows. These homeowners, who are often paying more to own a home than they would to rent a comparable home, and who often live pay check to pay check, making them vulnerable to relatively minor bumps in the road like an illness, rising utility and gasoline prices, or repairs that need to be done, find themselves leaving homeownership the hard way and hard pressed to even sell their homes through a realtor and recover their investment of what little savings they have accumulated.
Proponents of the subprime mortgage market argue that they are giving people a chance to be homeowners. But, the reality is, that a very large share of people who answer that call are making decisions that are economically unwise for them. The problem is not that there is anything sacred about a particularly numerical interest rate, but that rational participants in the market would not make the choice and government appropriately protects people who make economic choices primarily because they are ill informed, or, equally often deceived by slick mortgage brokers offering them bad deals.
Let's hope that this issue is mitigated, at least a little, by having Governor Owens sign the widely supported bill to regulate mortgage brokers in this state passed by the General Assembly this session. If criminals are taken out of the mortgage brokerage profession, many of these economically harmful deals for low income consumers might not happen at all. I'm not optimistic, but one can always hope.Footnote
There is an entirely different set of arguments against homeownership for middle class people who can afford conventional mortgages, not addressed above. But, in this case the argument is not that middle class condominium buyers or those selling them are making unwise decisions given their individual circumstances, but that the tax incentives for homeownership over leasing that drive those transactions encourage ownership arrangements that are not desirable in the absence of tax incentive.
This is particularly true in high rise buildings that go from apartments to condominiums. In these kinds of buildings, the collective action issues associated with homeowner's associations, make favoring home ownership a dubious choice from a non-tax perspective. Homeowner's associations tend to favor maintenance at the level desired by a median homeowner, even if some owners would favor much more maintenance, and require much more effort to make even easy decisions. Landlords, who wants to maximize the rental value of all the units in the aggregate and can make decisions quickly, in contrast, usually make better maintenance decisions in situations, like high rises, where the interests of each homeowner are often quite different. Consider, for example, the issue of elevator maintenance.
The best solution to this problem is to either (1) eliminate the mortgage interest and property tax deductions, or less disruptively, to (2) create a rent deduction and a deduction for casualty insurance on a principal residence. Either approach would create near tax parity between renting and owning and eliminate the kind of individually rational, but economically unwise tax driven decisions that our tax code's bias in favor of home ownership creates.