(This is Part 2 of a two-part series. Read Part 1, “Tighter lending rules could backfire.”)
A widespread view held by bank regulators, community groups and some legislators is that all home mortgages should be “affordable,” and government should do what is necessary to bring this about.
Last week, I looked at one concrete proposal designed to ensure the affordability of adjustable-rate mortgages (ARMs). It was to require lenders to qualify ARM borrowers not at the initial interest rate but at the “fully indexed rate,” which more closely approximates the rate at the first and second rate adjustments.
I pointed out that this rule would have little or no force because lenders could evade it with impunity if they wished to. Further, it is not at all clear that we would want such a rule to be effective, because every foreclosure prevented by the rule would also prevent a larger number of families from attaining home ownership.
This article points up another shortcoming of the “all loans should be affordable” idea. Some unaffordable loans are clearly in the interests of borrowers. Reverse mortgages are an obvious example, but there are many others that are not so obvious. The following examples are based on letters from my mailbox.
Need to Stay in House: Mary M. is a widow who owns a house worth $2 million with no mortgage. Her income, however, dropped precipitously when her husband died and is now barely enough to pay the property taxes. She plans to live with her children starting in five years, and wants to remain in her house until then.
To accomplish this, Mary takes out an interest-only 30-year fixed rate mortgage for $1 million at 8 percent, which costs her $6,666 a month. She immediately invests the $1 million in a pay-out annuity that yields 5 percent over five years, generating cash flow of $18,793 a month ($16,667 of this is the repayment of her $1 million). Net of the mortgage interest, her cash flow is $12,127 per month for five years, which meets her needs. At the end of five years, she sells the house and pays off the loan.
This loan is unaffordable, but it is a perfectly sound loan for the lender to make, and it allows the borrower to maintain her lifestyle.
Financial Emergency: Chuck T. learns he is going to be laid off in two weeks and will have no income for four to 10 weeks. His financial reserves are not large enough to pay his mortgage during this period, but he has equity in his house, which is a type of financial reserve. He uses it to take out a second mortgage in the form of a home equity line of credit (HELOC), which allows him to stay current on his first mortgage.
Chuck can’t afford the HELOC when he gets it because he has no income. Nonetheless, it is well-secured by his house, and it is paid off along with the first mortgage when Chuck finds a new position.
Confidence in Rising Income: John M. is a young physician with two years remaining on his residency. His annual income now is $50,000 but in two years it will be at least $150,000. Instead of buying a small house now and then upgrading in two years, which is extremely costly, he wants to buy the larger house now based on his income in two years.
Underwriters will not qualify a borrower using expected future income, no matter how well grounded the expectation is. John’s current income is too small to qualify for a loan large enough to purchase the house he wants using any of the standard mortgages. However, he can qualify with his current income using an option ARM on which the initial minimum payment can be calculated at a rate as low as 1 percent. While the payment rises slowly over time and may jump sharply after five years, John will be well prepared for it.
In all these cases, lenders made good loans that were well secured. The first two were unaffordable by the borrower at the time they were made. The third would have been unaffordable if the lender had been barred from qualifying the borrower at the very low interest rate in month one, as the bank regulators have proposed.
If the affordability police force institutional lenders to reject loans of these types, the loans will gravitate to “hard-money lenders.” These are mainly individuals who base loan decisions strictly on the collateral, care not a fig about affordability, are outside the reach of any affordability rules, and charge very high rates. The prospect that government will require that institutions make only affordable loans makes them drool.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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