Home loans fixed at 5 percent for a 20 or 30 years could be a possibility for more than 2 million buyers if a plan for "indexed" mortgages is implemented, the House subcommittee on housing and community development was told last week. In contrast to other plans Congress is now considering to bail out the ailing housing and savings and loan industries, no government subsidies would be required, several of the witnesses said.
The major catch to the low-interest loan proposal is that while the interest rate would stay at a moderate, fixed rate for the life of the mortgage, the principal against which that rate is applied would be adjusted each year according to increases or decreases in some standard index, such as the Consumer Price Index.
In this way, the borrower and the lender would share equally in the risk posed by inflation. Thrift institutions saddled with many low-paying, long-term mortgage loans have in recent years tried to shift much of the risk of future inflation to home buyers with such financing instruments as variable-rate mortgages. These offer strong protections for lenders against increases in interest rates, but provide little corresponding protection for borrowers.
The alternative, as presented in the congressional hearings, is to have a mortgage with payments that would increase in a manner predictable to the lender and borrower.
An "indexed mortgage," also called a "real-dollar mortgage" or a "price-level-adjusted mortgage," would have monthly charges that would be much below those of current mortgages, but that would increase in future years. While homeowners' costs would go up in nominal dollars, they would not increase in "real dollars"--dollars adjusted for inflation.
A home purchaser with a traditional fixed-payment mortgage of $50,000 at 14 percent for 30 years would pay the same amount in "nominal dollars"--$592 per month--for the entire loan term. If inflation were 10 percent a year, the homeowner would make "real-dollar" payments of $539 a month in the second year and $490 in the third.
An indexed mortgage, in contrast, would have constant real-dollar payments for its entire term.
For example, a 30-year indexed mortgage of $50,000 at 4 percent interest would cost $239 per month in its first year. If inflation were at 10 percent, the monthly charge would rise to $263 in the second year and $289 in the third year, in nominal terms. In real dollars, he cost would still be $239 per month.
These periodic adjustments would also cause the outstanding balance on the loan to increase over much of its term, instead of gradually decreasing as happens with a traditional fixed-payment loan. The balance due on the $50,000 conventional loan would drop to $49,883 at the end of the first year of payments and $49,750 at the end of the second. The holder of an indexed mortgage, however, would owe $54,031 at the end of the first year and $58,326 at the end of the second.
This "negative amortization" characteristic is one of the drawbacks of indexed mortgages, proponents acknowledge; many states have laws prohibiting negative amortization. Several of the witnesses suggested that Congress pass legislation overriding such state limits.
Such shortcomings of the new financing instrument are counterbalanced by the advantage of low initial monthly costs, the witnesses told the subcommittee.
Henry Cassidy, research director of the Federal Home Loan Bank Board, presented figures showing it is not until the 11th year that the payments under an indexed mortgage plan would equal those of a conventional mortgage. Cassidy added that studies done for the FHLBB have shown that most families' incomes would keep pace with inflation, so that they would pay about the same percentage of their income for their housing costs every year of the mortgage.
Indexed mortgages have seen little use in this country although they have been widely used in other nations, said another of the witnesses, Franco Modigliani, a professor of economics at the Massachusetts Institute of Technology.
The Timbers Corp., a New York real estate development company, first made indexed mortgages in 1979 in Westchester County, N.Y., and later in Agusta, Ga., saidthe firm's president, Robert Law.
He said a typical purchaser of a $30,000 home in Augusta in 1980 began paying only $189 per month, instead of the $330 he or she would have paid with a conventional loan at the then-prevailing rate of 12 percent. That same buyer is now paying $219 monthly, but would have to pay $440 per month at the current 17 percent rates with a traditional loan, Law said.
Recently the Utah State Retirement System began a $20 million indexed mortgage program, with its loans to be adjusted every six months according to increases in the Consumer Price Index. Borrowers pay 4 3/4 percent, plus the six-month average of the CPI.
Retirement funds could be one of the primary sources of money for indexed mortgages, said MIT's Modigliani. By investing in loans whose payments would increase with inflation, pensioners' incomes would be protected against the future ravages of inflation in a way that is true with few retirement funds today, he said.
For traditional thrift institutions to make indexed mortgages available, they would first have to introduce a program of indexed savings, the MIT professor explained, so that the initially low payments made by mortgage holders would match the initially low returns savers would receive.
A third possible source of indexed mortgage funds could be pools of indexed bonds sold to investors. The Real Dollar Corp., a subsidiary of Law's development firm, is currently seeking approval from the Securities and Exchange Commission to sell $5 million in indexed bonds to provide funds for indexed mortgages.
The Fund for an OPEN Society, a private, nonprofit Philadelphia mortgage company that tries to promote integrated neighborhoods with the loans it makes, recently approved a plan for an indexed bond and mortgage program. OPEN's bonds would pay investors between 2 and 5 percent, depending on their terms, and would be indexed to the Bureau of Labor Statistic's measure of average weekly earnings, said Roger Willcox, another of the witnesses.
Willcox, who is president of the Community Cooperative Development Foundation of South Norwalk, Conn., helped OPEN structure its program. Home buyers with OPEN loans would pay 7 percent interest and would have their payments adjusted annually.
Willcox helped introduce indexed savings and loans programs in Latin America in the 1950s and the 1960s. In Chile, Willcox reported, "Continuing inflation had destroyed the previous savings and loan industry and literally no mortgages were available for housing."
The Chilean indexed program was a tremendous success, he said, where, "for the first time in 20 years the general public was investing money in savings instead of in purchases of physical and personal property." A majority of countries throughout the world have indexed savings and loan systems in effect, Willcox told the subcommittee members.
For there to be widespread acceptance of indexed mortgages and savings in this country, there must first be several important legislative changes, the witnesses said. Now increases in the loan's principal value due to increases in the index are treated as ordinary income. Such rises should either be considered as capital gains and thus taxed at a lower rate, or be entirely exempt from taxes, as they are in England, Willcox said.
Congress should also approve legislation preempting state limits on negative amortization, Modigliani said.
Rep. Stanley Lundine (D.-N.Y.) said he would begin pushing the House of Representatives to adopt changes in amendments to this year's housing act to permit indexed mortgages. He also suggested that the Federal Housing Administration could be authorized to run a demonstration program to insure such loans.