A Straight Path to Wealth, and Debt-Free Homeownership
The Wealth Building Home Loan (WBHL), a new approach to home finance, was unveiled at the American Mortgage Conference on September 8. In developing the WBHL, my colleague Stephen Oliner and I were informed by long-forgotten standards set by a federal agency that is now celebrating its 80th anniversary. In 1934 the Federal Housing Administration (FHA) created what it called "a straight, broad, highway to debt-free home ownership" which protected home buyers with such features as 20 percent down payments, fully amortizing loan terms of 15-25 years, a full review of a borrower's household budget, and rigorous appraiser and appraisal standards,
Over the next 25 years the home ownership rate soared from 44 percent in 1940 to 62 percent in 1960. During this period the 30-year fixed rate loan played a minor role. And these loans were sustainable; over the 20-year period ending in 1954 FHA insured over 3 million home loans and had a cumulative claim rate of 0.20 percent. FHA's ‘debt-free highway' was also adopted by the VA and conventional lenders, enabling the Greatest Generation to burn their mortgages.
Until the mid-1950s FHA's debt-free highway was based on an underwriting grid and valuation practices that successfully limited layering one risk on top of another. Beginning in 1957 Congress enacted a series of increases in FHA's leverage limits that reversed this policy. By 1962 the FHA's mounting foreclosures were noted by Time magazine: "Homeowners of a new and unattractive breed are plaguing the Federal Housing Administration these days. Known as ‘the walkaways,' they are people who find themselves unable to meet their mortgage payments-and to solve the problem simply move out their belongings at night, drop their house key in the mailbox and disappear." By 1966 the FHA's foreclosure rate was six times higher than just 10 years before; a trend that would continue for decades. In 1992 Congress weighed in once again; this time mandating that Fannie and Freddie compete with FHA and subprime. The result was a crooked, rutted path leading to a graveyard of dashed dreams; millions upon millions of which were replaced by ‘indebtorship' and foreclosure.
A 2013 paper by Herbert, et. al. of the Harvard Joint Center for Housing Studies summed up this policy approach: "In many respects, the notion that owning a home is an effective means of accumulating wealth among low-income and minority households has been the keystone underlying efforts to support homeownership in recent decades."
For over 50 years U.S. housing policy has relied on ever looser underwriting standards in an attempt to lift the home ownership rate and stimulate the economy. The focus has been on low- and moderate-income home buyers in an attempt to build wealth for these households. This effort has failed miserably, with the national homeownership rate barely above that of 1962 and accumulated wealth for lower income households at the lowest levels in decades.
Today, leverage on home purchase loans remains at historically high levels: 93 percent have a 30-year term, 50 percent a combined loan-to-value of 5 percent or less, and 21 percent have a total debt-to-income ratio of greater than 43 percent. Yet FHA argues that we need to make many more risky FHA 30-year loans to borrowers with impaired credit (represented by FICO credit scores of less than 660). While FHA dismisses the increase in risk as minimal, the facts are that 30-year FHA loans to such borrowers have overwhelmingly high risk-an AEI Mortgage Risk Index (HousingRisk.org) score of 33 percent (meaning under a stress event similar to that which occurred in 2007, 1 in 3 loans would go to foreclosure).
Speaking at the American Mortgage Conference on September 10, Joseph Smith, monitor of the National Mortgage Settlement of the State Attorneys General and Lenders, asked: "[I]s the thirty year fixed-rate mortgage what we need? ... While it is a proven ‘affordability product' of long standing, the thirty-year fixed-rate mortgage does not build equity very quickly. Further, a lot of things can happen to a borrower over those thirty year-job loss, health problems, divorce.... Absent substantial home equity at the outset, the thirty-year fixed rate mortgage increases the fragility of a borrower's overall financial position and puts the borrower at risk for a very long time."
Smith went on: "If we want to keep homeownership an option for an expanding portion of the population, we should build some additional features into the mortgage product to reduce fragility. At the very least, we should consider the inclusion of product features that allow and even encourage early equity build-up. In that regard, I am pleased to note AEI's Wealth Building Home Loan."
Steve Oliner and I created the WBHL to serve the twin goals of providing a broad range of homebuyers-including low-income, minority, and first-time buyers-a more reliable and effective means of building wealth than currently available under existing policies, while maintaining buying power similar to a 30-year loan. A WBHL has a much lower foreclosure risk because of faster amortization and common-sense underwriting. Its monthly payment is almost as low as a 30-year, fixed-rate loan while providing the buyer with more than 90 percent of the buying power. It requires little or no down payment and has a broad credit box, meaning sustainable lending for a wide range of prospective homebuyers. The WBHL is designed to reduce default risk for all borrowers; a feature of critical importance for borrowers with FICO scores in the range of 600-660-borrowers largely served by high risk FHA loans today. These same loans originated as WBHLs would have an estimated AEI Mortgage Risk Index score of 10% under a 2007 stress event, 70 percent less than a similar FHA 30-year loan.
In the first three years of a WBHL, 77% of the monthly mortgage payments pay off the principal, creating huge amounts of equity, while for a 30-year loan, 68% goes to pay interest. During the same three years, the WBHL with a 0% down amortizes to an 82% Loan-to-Value ratio (LTV) while a 30-year fixed rate FHA loan with 4% down payment amortizes to a 91% LTV. With the WBHL you own your home free and clear in 15 years. Just as important, in year 16, you have free cash flow for life cycle needs such as your children's education. With the 30-year loan you may be making mortgage payments well into retirement.
The WBHL is a straight, broad highway to debt-free homeownership. Low- and middle-income homebuyers deserve nothing less.
