An unprecedented surge in long-term interest rates has carried mortgage rates to 17 percent, an increase of nearly six percentage points in just two years. The resulting jump in monthly mortgage payments has cut back sharply the demand for new homes. The home construction rate has dropped to less than 1 million units a year, only half the 1978-79 rate.
With figures like these, it's not surprising that potential home buyers and sellers alike, along with the construction industry, are turning in protest to their representatives in Washington. The temptation will be strong for Congress and the administration to try to force the Federal Reserve to ease credit or even to try some form of credit controls or direct intervention in mortgage markets. Any such move would weaken the administration's anti-inflation program without resolving the fundamental problem in the financing of homeownership.
The plight of the potential home buyer is a serious one. Even for relatively affluent families, the usual method of financing a home purchase can impose prohibitive initial carrying costs.
It would certainly not be unreasonable by conventional standards for a couple with an annual income of $40,000 to aspire to an $80,000 home. But with a normal down payment of 20 percent and a 17 percent interest rate on the loan of $64,000, this couple would be spending $11,000 a year on mortgage payments alone-- more than one fourth of their annual income.
It's true that the federal government would assist this couple by allowing the deduction of these interest payments in the calculation of taxable income. But even after a tax saving of $3,200, the net annual mortgage cost of $7,800 would still take nearly one-fourth of the couple's income net of federal and state taxes.
Furthermore, even if a couple is willing to take on this burden, they often find it impossible to obtain credit. Banks and savings and loan associations are frequently unwilling to take the risk of lending to a couple for whom meeting the monthly payment represents a serious financial strain. The financial institutions understandably fear that if the couple experiences even a temporary loss of income or large unexpected expenditure, the mortgage might be thrown into default.
But serious as the problem is, it would be wrong to seek a solution in artificially low mortgage interest rates. Imposing a ceiling on the interest rate that could be charged on mortgages would simply dry up all of the supply of mortgage funds as lenders turned to the corporate and government bond markets instead. Similarly, a return to the old regulations limiting the interest rate that banks and thrifts can pay for their funds would not only distort savings incentives but would induce an outflow of funds from which the savings banks and the S&Ls might never recover.
Alternatively, a direct government subsidy that lowered mortgage rates and thereby permitted home buyers to borrow at a lower cost of funds than businesses would mean that too much of the nation's savings would flow into housing and not enough into investment in plant and equipment.
The correct solution to the problem is to reduce the borrower's monthly repayment burden without distorting the cost of borrowed funds. Fortunately, it is possible to alleviate the heavy initial carrying cost without creating wrong incentives for savings and investment.
The real problem for the home purchaser is not the high mortgage interest rate in itself but the flat monthly payments for interest and amortization. Monthly mortgage repayment under current home financing arrangements is spread in equal dollar installments over a period of up to 30 years. But equal dollar installments may mean very different payments of real purchasing power when inflation reduces the value of a dollar very substantially over a period of two to three decades.
With the usual method of constant monthly payments, most of the real value of the loan is actually repaid in the first few years even if payments continue for 30 years. For example, at 7 percent inflation, the annual payment of $11,000 referred to earlier declines in terms of purchasing power from $11,000 in the first year to $5,600 a decade later, less than $3,000 in the 20th year and only $1,500 in the final year. If the couple's real income just keeps pace with inflation and enjoys no real growth, a constant monthly payment mortgage that took a very burdensome 25 percent of income in the first year would take a very moderate 10 percent of income 15 years later. And if the couple's income growth exceeds inflation by 2 percent a year, it would take only a decade to reduce the mortgage payment to 10 percent of income. The problem is, therefore, to avoid the heavy burden of the first few years by shifting more of the repayment to later years.
In place of the present system of fixed monthly payments, mortgage payments should increase gradually with the general rise in prices and incomes. In this way, the purchasing power value of the repayment installments could remain constant or even increase as real income grows.
The principle of gradually increasing mortgage payments could be incorporated into any of the currently available types of mortgages. A bank might, for example, issue a 30-year mortgage with a 17 percent interest rate, but, instead of a constant monthly repayment, might use a repayment schedule that starts low and then rises at 6 percent a year. Such a change would permit cutting the annual mortgage payment in the first year from $11,000 to $7,000 or, net of the benefits of tax deductibility, from $7,800 to $4,800. This reduction of nearly 40 percent in first-year payments shows how much relief could be achieved without distorting interest rates.
Permitting monthly payments to increase at an annual rate of 6 percent over the entire life of the mortgage does run the risk that they will become too high relative to income in later years if inflation falls sharply. This risk can be greatly reduced by using a mortgage in which monthly payments increase only for a limited time and then remain level. Fortunately, a 6 percent rate of increase limited to the first decade and followed by constant monthly payments would still succeed in reducing the $11,000 first-year mortgage repayment to only $7,900 (with a correspondingly smaller net-of-tax amount).
In the last few years, banks and thrift institutions have introduced "variable rate" mortgages in which the interest rate is periodically adjusted up or down in response to the general movement of interest rates. A variable interest rate could easily be combined with a graduated payment schedule. Indeed, a variable rate may be necessary to induce lenders to accept the greater risk that is associated with slowing the rate at which the loan is repaid. It is unfortunate, therefore, that the government still restricts the use of variable rate mortgages. By doing so, it discourages lenders from offering the kind of graduated payment mortgages that could substantially ease the burden of home buying. The government's restrictions on the use of variable rate mortgages have been eased in recent years, and the remaining restrictions should be eliminated as quickly as possible.
It is crucial for the government to avoid the temptation to lower mortgage interest rates by an inevitably futile policy of easy money. Such an increased growth of the money supply would only add to inflation and thus ultimately raise interest rates. Let's hope that Congress and the administration have instead both the wisdom to eliminate the restrictions that are impeding change and the patience to allow the market to solve the mortgage problem.