A Straight, Broad Highway to Building Wealth for Middle and Working Class Families through Homeownership and Retirement Savings

Edward Pinto,

Codirector

AEI International Center on Housing Risk

HousingRisk.org

American Enterprise Institute

September 8, 2014

The views expressed here are those of the author alone and do not necessarily represent those of the American Enterprise Institute.

HousingRisk.org | 1

PRESENTED AT THE WEALTH BUILDING HOME LOAN PRESS BRIEFING HELD IN CONJUNCTION WITH THE 2014 AMERICAN MORTGAGE CONFERENCESPONSORED BY THE NORTH CAROLINA BANKERS ASSOCIATION

‘Mortgage’ has become another word for trouble

• Home price appreciation rates are modest and averages mask volatility

– No diversification when one’s wealth is in a single asset

– “The housing market is a ‘crapshoot’”—Professor Karl Case1

• 30 year term and high debt ratios maximize debt and trap families, especially those with low income, in a cycle where they can’t build wealth

– From 1977-2012, 1 in 8 families with an FHA loan lost their home

1 http://money.cnn.com/2014/07/07/investing/housing-market-case/ July 7, 2014

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House Price Volatility, 50 Largest Metro Areas

Note: Each series shows the percent change from 20 quarters (5 years) earlier. Volatile metros are defined as those for which the difference between the highest and lowest annual percent changes is more than 30 percentage points. All other metros are in “more stable” group.Source: AEI International Center on Housing Risk, www.HousingRisk.org, using data from Zillow.com 3

House prices are very volatile in many metro areas, less so in others. But even in

the more stable metros, there is substantial variation across neighborhoods.

-80%

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1984 1987 1990 1993 1996 1999 2002 2005 2008 2011

California metros

Other volatile metros

More stable metros

What is the Wealth Building Home Loan—WBHLSM? • 15-year, fixed rate loan • Requires little or no down payment with broad credit box • Monthly payment almost as low as on a 30-year, fixed rate loan• Much lower foreclosure risk due to faster amortization and common-sense

underwriting • Broad eligibility for prospective homebuyers

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Unlike Most Loans, You Build Substantial Equity In Just A Few Years And You Own Your Home Free And Clear In Just 15 Years

The Wealth Building Home LoanSM

WBHL: Faster amortization = less interest

• In the first three years of a WBHL 77% of monthly mortgage payments pay off principal, creating huge amounts of equity, while for a 30 year loan, 68% goes to pay interest.

• Own your home free and clear in 15 years• In year 16, you have free cash flow for life cycle needs such as your children’s

education • Greater market stability for all Source: Calculated based on 1.875% bought-down interest rate on 15 year and 4% rate on 30 year (30 year includes upfront FHA premium of 1.75% financed in mortgage. http://bretwhissel.net/cgi-bin/amortize 5

70% lower foreclosure risk yields superior borrower protection

• WBHL: an owner-occupied 15-year fixed rate, fully amortizing loan– Superior wealth building through principal repayment (Appendix 1)– Lower interest rate due to reduced investor duration risk

• Foreclosure risk about 70% less than for a 30-year loan– Faster amortization reduces default by about 50 ppt.– Common sense underwriting reduces by another 20 ppt.

• Borrower ability to repay includes residual income analysis similar to that used by the VA1

• Rigorous appraisal and appraiser standards similar to those used by the VA• Enforceable restrictions on ability to take out second lien and convert to

rental• Superior protection for borrowers with a FICO score below 660• Allows for repurposing of down payment funds to buy down rate further

1The VA has applied the residual income method since its establishment. VA considers DTI secondary to residual income as an underwriting factor. See Chapter 4: VA Credit Underwriting. See also “VA Loans Outperform FHA Loans. Why? And What Can We Learn?” http://www.urban.org/publications/413182.html

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Why the Wealth Building Home Loan works• Delivers more than 90% of the buying power of a 30-year FHA

loan from combined effect of four factors: – Conventional 15-year loan rate 0.75% below FHA 30-year rate – Lower annual credit risk expense1

– The strong savings component safely allows for a slightly higher housing DTI ratio

– A maximum LTV of 100% allows for repurposing 5% down payment for a 1.25% permanent rate buy down

– WBHL pilots in development

• The Low-Income2, First-Time Homebuyer3 (LIFT Home) WBHL will provide about 100% of the buying power of a 30-year FHA loan

• The Neighborhood Assistance Corp. of America (NACA) pilot underway• Other LIFT Home pilots in development

1Based on FHA premium on 30-year loan of 1.75% upfront and 1.30% annually vs. estimated WBHL annual credit risk expense of 0.50% annually 2First time homebuyer definition: has not owned a home in the three prior years. 3First-time homebuyers at <80% of the area median income (AMI)

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Life Cycle: Savings and Spending1

• Age 25-29: $24,000 in accumulated wealth by age 29 – Participate in employer matched savings plan

• Age 30-51: $600,000 in accumulated wealth by age 51 (6.6 times annual income)– Buy first home with a WBHL using savings for buy down, continue with savings plan – After 7 years, buy move-up home with WBHL, continue with savings plan2

– At age 52, make final payment on move-up home purchased with a WBHL

• Age 52-56: $750,000 in accumulated wealth by age 56 (7.5 times annual income)– Use freed up annual cash flow ($13,000 in 2014 dollars) for children’s post-high

school education, continue with savings plan

• Age 57-64: $1,100,000 in accumulated wealth by age 64 (9.5 times annual income)– Children complete post-high school education– Use 50% of freed up annual cash flow ($6500+ in 2014 dollars) to increase retirement

savings

• Age 65:– Enter a comfortable retirement

1llustrative only. Assumes household income of $53,000 (US median household income from Census Bureau) and that wages increase at 2% annual inflation rate. If inflation rate higher, wage increases, house appreciation and stock market return likely also higher. Base on a 4% employer contribution (through age 56 and 4% employer match (through age 58).2Assumes move-up home costs 35% more than price of home being sold and with a 25% down payment. 8

Other benefits of the WBHL• More stable housing market

– Prudent and sustainable expansion of credit availability– Reduces leverage in housing finance market – Reduces likelihood a housing downturn would spark a financial crisis

• Much smaller revenue loss for Treasury from tax deduction for mortgage interest

• Less reliance on government – Reduces burden of social safety net on Treasury– Reduced need for mortgage guarantees means less taxpayer liability

• Less capital required by institutions bearing credit risk

• Reduced prepayment risk for mortgage investors– Interest rate buy down reduces incentive to refinance– Cuts socially wasteful costs associated with refinancing

• Promotes and leverages employer provided Defined Contribution (DC) plans 9

Demonstrated ability to bridge the Left-Right gap

• The WBHL has broad appeal – it creates sustainable homeownership and promotes saving and wealth building over a household’s life cycle

• Bruce Marks, founder and CEO of the Neighborhood Assistance Corp. of America (NACA), and I are here today because we recognize that our current housing finance policy fails to reliably build wealth (Appendix 2), results in frequent defaults, fails to consider retirement savings (Appendix 3), and keeps families in debt

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Background Material:Building Wealth for Middle and

Working Class Families

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Appendix 1: the WBHL1 enables low-, moderate-, and middle income families to build real wealth

Note: Median family net worth, by income percentile bracket, median values displayed in thousands of dollars, 1989–2010 Survey of Consumer Finance. The 50th percentile of income equals median income. The 20-39.9th percentiles roughly equate with low-income (50-80% of median income). 1LIFT Home WB-100 NACA w. 401(k): LIFT Home WBHL with 100% LTV, 4 points used for permanent rate buy down, and homeowner participates in available 401(k). Does not assume home is sold at end of 7 years.

MI WB-100 w. 401(k): MI WBHL with 100% LTV, 5% down payment funds used for permanent rate buy down, and homeowner participates in available 401(k). Does not assume home is sold at end of 7 years. 12

Appendix 2: Wealth Building• Wealth is the antidote for poverty

• Wealth equals one’s accumulated savings

• Wealth building has been ignored for 50 years:– “Policy makers often focus on income and overlook

wealth, but consider: the racial wealth gap is three times larger than the racial income gap.1

• Fixed rate, high LTV 15-year loans accumulate wealth quickly and perform well2

• Middle and working class families need a straight, broad highway to wealth building

1The racial income gap is three to one, while the wealth gap is nine to one. Less than Equal: Racial Disparities in Wealth Accumulation, Signe-Mary McKernan, Caroline Ratcliffe, Eugene Stanley, and Sisi Zhang, Urban Institute, April 20132 http://blog.metrotrends.org/2014/01/fast-pay-off-payment-loans-perform/

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Appendix 2: Adjust spending to savings needs

• Martin Luther King Jr. recognized the problem of living beyond one’s means in his 1968 “The Drum Major Instinct” sermon– “Now the economists also say that your house shouldn’t cost—

if you’re buying a house, it shouldn’t cost more than twice your income. That’s based on the economy and how you would make ends meet. So, if you have an income of five thousand dollars, it’s kind of difficult in this society. But say it’s a family with an income of ten thousand dollars, the house shouldn’t cost much more than twenty thousand. Well, I’ve seen folk making ten thousand dollars, living in a forty- and fifty-thousand-dollar house. And you know they just barely make it. They get a check every month somewhere, and they owe all of that out before it comes in. Never have anything to put away for rainy days.”1

1Martin Luther King Jr. “The Drum Major Instinct” sermon, Atlanta, GA, February 4, 1968.14

Appendix 3: Dramatic Changes in Pension Savings

• In the early 1970s defined benefit (DB) plans the norm– With little or no employee contribution, the impact on the

employee’s budget was minimal

• Today, defined contribution (DC) plans the norm, accounting for 78% of pension plans,1 with most DB plans being legacy – $4.5 tril. in total assets (another $6.2 tril. held in IRA assets)2

– Most require a pre-tax employee contribution to trigger an employer match2

– Employee and employer-match DC contributions average 6.8%and 4.5% respectively2

– Quick vesting 401K plans are well-suited to a mobile workforce3

– Provides investment capital for job creating assets1Source: http://www.ebri.org/publications/notes/index.cfm?fa=notesDisp&content_id=52562Source: http://www.americanbenefitscouncil.org/newsroom/2014/pr14-08.cfm3 Source: http://www.ebri.org/publications/notes/index.cfm?fa=notesDisp&content_id=5256

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Appendix 3: Stock market returns over the same period were much higher than on homes

• Over 1996-2013 the S&P 500 had annual compound returns of:1

– 8.7%/5.9% (nominal/inflation adjusted $)

• This compares to national home price compound returns over 1996-2014 of:– 3.5%/1.3% (all homes in nominal/inflation adjusted $)2

– 2.8%/0.2% (lowest price tier in nominal/inflation adjusted $)3

• Most home price appreciation due to inflation, not real growth• Working class and middle income families would benefit from

taking advantage of the combined wealth building capabilities of home ownership and retirement investments

1http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html2Based on unweighted average for all homes by state for 38 states with available data. Source: Zillow3Based on unweighted average for lowest price tier by state for 36 states with available data. Source: Zillow

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