Financial planners emphasize the importance of healthy savings for building financial security. Equally important, but less often emphasized, is that a family's accumulation of wealth depends on the home mortgage it chooses.
The Federal Housing Finance Agency, Fannie Mae and Freddie Mac are busy making plans to loosen mortgage underwriting standards. These new policies are aimed at stimulating the housing market rather than putting families into mortgages that give them the best odds of a solid financial future. We think housing policy needs to focus on long-term stability for families as well as the economy. This goal is best accomplished by discouraging the use of the 30-year mortgage and promoting new mortgage products that quickly build home equity.
Many interest groups benefit when regulators tilt the rules to qualify marginal borrowers for mortgages they really cannot afford. All too often, however, homebuyers end up on the losing end. The recent financial crisis revealed the danger of temporarily stimulating the housing market by encouraging lending to less creditworthy borrowers.
The Dodd-Frank Act mandated new regulations in an attempt to prevent another mortgage crisis. However, many of these new rules seem unlikely to benefit borrowers or the financial system in practice. The qualified mortgage rules developed by the Consumer Financial Protection Bureau set minimum underwriting standards for loan quality. But these standards are waived for loans that are guaranteed by Fannie, Freddie or the other government programs that dominate the home mortgage market today. The fact is, the QM rules do relatively little to promote financial stability. The situation will only get worse if lenders acquiesce to political pressures to reduce underwriting standards.
Housing policy needs to be refocused on strengthening household balance sheets, especially by making borrowers more resilient to home price declines. The new Wealth Building Home Loan developed at the American Enterprise Institute does exactly that. It takes risk out of the financial system by giving borrowers especially low- and middle-income households a much safer path to homeownership and financial security than a 30-year mortgage that pays off very slowly, imposing a heavy debt burden for years to come.
The WBHL is a 15-year fixed-rate mortgage with features designed to reduce risk and increase affordability. With a 15-year amortization, homeowner equity builds quickly. The WBHL effectively imposes the savings discipline that most personal finance guides recommend. As borrowers make regular mortgage payments, they build wealth in their home savings account, in the form of home equity.
The WBHL requires little or no down payment. Borrowers use part or all of the usual down payment to buy down the interest rate on the loan. In today's market, paying 5 points upfront would reduce the interest rate on a 15-year mortgage to about 2% for the life of the loan. For low-income borrowers, the rate could be brought down further using financial assistance from lenders, foundations or government programs. The buy-down lowers credit risk by giving borrowers a strong incentive to stay current and benefit from the favorable interest rate.
The final key element of the WBHL is its use of sound underwriting and appraisal procedures that adhere closely to those employed by the Department of Veterans Affairs. The VA's residual income underwriting looks beyond the standard debt-to-income ratio enshrined in the QM rule, focusing instead on the entire household budget to ensure that the borrower can comfortably meet other living expenses while paying down the mortgage.
Widespread adoption of the WBHL would sharply lower the odds of another financial crisis. Because these loans amortize quickly, instances of negative equity would be unusual, even in areas with volatile house prices. And as equity builds, borrowers will make every effort to avoid default.
Moreover, if borrowers encounter unforeseen payment difficulties, lenders have an incentive to offer remediation options because borrowers with equity are more likely to remain current after a loan modification. Even in a worst-case scenario, there is a good chance that the homeowner could sell the house and pay off the loan.
The WBHL is not simply a pie-in-the-sky idea. In early September, the Neighborhood Assistance Corporation of America, a national nonprofit, began offering WBHLs. A number of lenders and mortgage insurers are also in discussions with AEI housing experts to broaden the availability of the WBHL.
A few simple actions by financial regulators would help speed wider adoption of this low-risk loan. First, the CFPB could help by revising the QM rules to grant a safe harbor to WBHLs in recognition of their fast amortization and use of residual income underwriting. Under the current QM rules, the cap on borrower-paid fees and points restricts the use of the interest rate buy-downs, thereby harming the households that would benefit the most from the WBHL.
In addition to revising the QM rule, financial regulators could promote the WBHL and other loans that reduce the risk of homeownership and reliably build home equity. Financial education efforts should discuss with borrowers the benefits associated with alternatives to the standard 30-year loan.
We have seen all too clearly the damage that excess mortgage leverage and housing bubbles can do to Main Street. The best way to avoid a repeat of the recent financial crisis is to encourage the extension of safer mortgages that build home equity. The Wealth Building Home Loan is a step in that direction.
Paul H. Kupiec and Stephen D. Oliner are resident scholars at the American Enterprise Institute. Mr. Oliner is also co-director of AEI's International Center on Housing Risk and a senior fellow at the Ziman Center for Real Estate at the University of California, Los Angeles.