Rebuild the path to the American homeownership
As it stands, the American dream is undermining our economy.
Our society rightly values homeownership, high rates of which are tied to better educational performance among children, lower crime rates and less dependency on government programs. But the principal pathway to homeownership, the 30-year mortgage, is less than optimal for consumers and financial institutions.
More than nine out of 10 U.S. homeowners have long-term, fixed-rate loans. But the 30-year fixed-rate loan is dangerously outdated. It was created in the late 1940s, when the economy was fundamentally different. Just as fewer Americans remain with one company over their careers, fewer Americans remain in one home over their working lives.
And while a locked-in interest rate can provide peace of mind, consumers pay for that stability in front-loaded interest costs, slow buildup of equity and the many fees associated with refinancing or remortgaging. Last week, according to the Mortgage Bankers Association, refinances accounted for nearly 83 percent of mortgage applications.
If Congress is going to play a role in the housing market, it should create an incentive for consumers to pay down their principal home cost more quickly and accumulate equity. The tax deduction for mortgage interest payments encourages Americans to purchase homes, but the break comes on the wrong part of the loan -- the interest, not the principal.
Lawmakers should gradually replace this deduction with a national tax credit that rewards payments on mortgage principal. To prevent gaming of the system, the credit would need to be capped, just as Americans are limited in contributions to their 401(k)s each year. And to ensure that this tax credit helps everyday Americans accumulate equity, lawmakers could impose an income cap similar to the one that limits eligibility for Roth IRAs to those with annual incomes below $120,000.
This tax credit could work well for consumers and banks. Shorter-term, fixed-rate loans generally carry lower risks for banks than 30-year loans do, resulting in lower interest rates. On a typical $225,000 mortgage, a buyer who gets a five-year, fixed-rate mortgage at 3.50 percent might well pay 4.75 percent for a 30-year loan. The savings would come to more than $11,000 when it's time to refinance the five-year agreement.
The savings generated from shorter-term loans could be put directly toward paying down the principal by consumers eager to build equity. Instead of chipping away at their mortgage over half a lifetime, people would achieve the security that comes from homeownership much faster -- and our nation would be encouraging savings, not debt. And anyone worried about a potential rise in interest rates could simply refinance at a different point or for a slightly longer period.
Increased use of shorter-term loans would also bring much-needed stability to the mortgage market and help protect against bubbles.
Most local banks, or local branches of big banks, can't afford to keep 30-year commitments on their books. The 9,000 banks, thrifts and credit unions that underwrite mortgages in this country gradually turned to securitization -- in which loans are repackaged into securities and then sold into the bond market -- precisely to get overly long risk commitments off their books and turn those 30-year contracts into more flexible financial vehicles.
Greater demand for shorter-term, fixed-rate mortgages, amortized over 30 years, would enable banks to keep the loans on their own books.
Our neighbor to the north proves that this works. Canadian banks hold about 75 percent of their loans on their books. And the mortgage rates for Canadian loans are fixed for a statutory maximum of five years. After the fixed rate expires, the mortgage rate is renegotiated. As University of Michigan economist Mark Perry has explained, "This practice allows banks to achieve a better maturity match between their assets (mortgages and loans) and interest income, and their liabilities (deposits) and interest expense."
In Canada, mortgage interest is not tax-deductible. So there's no tax advantage to dragging out one's payments for years. In fact, paying extra to reduce the principal of a home loan and build equity reduces the size and duration of future interest payments.
Not surprisingly, banks and homeowners up north fared much better than those in the United States during the global recession. While about 14 percent of U.S. mortgages are in arrears, less than 1 percent of Canadian mortgages are in foreclosure or delinquent. And the Canadian real estate market has rebounded beyond pre-recession levels.
The U.S. mortgage market needs to join the rest of the economy in the 21st century. By encouraging shorter-term loans and incentivizing principal payments, lawmakers can help the mortgage industry evolve.
The writer is president and chief executive of ING Direct USA.