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Patricia McCoy: The fixed straight mortgage is your friend, and it has this beautiful silver lining, which is that as your income goes up, your mortgage payment will feel cheaper and cheaper with each passing year, and that is a beautiful thing.
Stephanie Kelton: Welcome to the Best New Ideas in Money, a podcast for Market Watch. I’m Stephanie Kelton. I’m an economist and a professor of economics and public policy at Stony Brook University. Each week we explore innovations in economics, finance, technology, and policy that rethink the way we live works, spend, save and invest. Charles Pasi will be back next week.
Do you dream of owning a home or apartment, but fear you may never be able to afford a down payment? You’re not alone. While home ownership continues to symbolize the American dream, for many Americans that dream remains out of reach. Home ownership is broadly important. It’s the primary way that most families build wealth, but a home isn’t just an asset. It’s also the place where you live and maybe raise a family. And although factors like a lack of affordable housing and especially a shortage of starter homes are among the difficulties many would be home buyers face, one of the most significant barriers to home ownership is often the down payment.
Earlier this year, the median sale price of a home in the United States was just over $440,000. To make a 20% down payment on that home, you’d need almost $90,000. The real median income in the United States, according to the Census Bureau was $70,784 in 2021. It comes as no surprise then that Bank of America got a lot of attention when it recently announced it would begin offering zero down payment mortgages in an effort to expand home ownership in black and Hispanic communities in a handful of cities in the United States.
Patricia McCoy: It’s a pilot project. It is being offered in black and brown neighborhoods in five or six cities around the United States. And the interesting thing about this mortgage is that it requires zero down payment and also zero closing costs.
Stephanie Kelton: That’s Patricia McCoy, a professor at Boston College Law School, who studies the relationship between mortgage markets and financial crises. So how does the zero down payment, zero closing cost pilot program work? According to Bank of America, prospective home buyers are evaluated based on credit guidelines that include rental, utility, phone, and auto insurance payments. Eligibility is based on income and location and neither a minimum credit score nor mortgage insurance are required, but borrowers must complete a federally approved home buyer certification course.
Patricia McCoy: These zero down payment loans are not new. There are different ways that zero down payment loans have been offered in the past. For example, the Veterans Administration has long offered a zero down payment loan to veterans and has a lot of experience managing that. We’ve also seen zero down payment programs or down payment assistance offered by local housing agencies across the United States. What makes this interesting is that it’s being offered by one of the biggest banks, a private lender in the United States.
Stephanie Kelton: It isn’t only about the down payment. The Bank of America pilot aims to address persistent racial gaps in home ownership.
Patricia McCoy: If we look at white and black home ownership rates, there is almost a 30 percentage point gap between the home ownership rate of whites and that of blacks.
Home ownership is the single most effective way of building wealth in America. In past decades, black households were barred from home ownership by law, by federal law, and by state and local laws as well as private discrimination. And so those families have already for forgone generations of wealth formation. Today, the problem is not legal discrimination. The problem is inability to get a mortgage. So the zero down payment mortgage is very important in motivated by a hope to help black families and other families of color get their feet on the first rung of home ownership as a path to building wealth.
Stephanie Kelton: It’s important to note that anyone of any race may apply for these mortgages. And as of now, Bank of America has no set number of mortgages it plans to offer. It’s a test and learn pilot according to a spokesperson. It’s an interesting idea, qualifying more borrowers, thereby expanding access to home ownership, but it’s not without real risks.
Patricia McCoy: When a first time home buyer buys a house with a zero down payment mortgage, 100% of the purchase price is being financed by the lender. Let’s say down the road that our borrower encounters some difficulty making the monthly payments. This could happen because their hours on the job have been cut, or perhaps they’ve lost their job, they’ve gone through a divorce, et cetera. Various life events happen where people can have trouble making their mortgage payment. And let’s also imagine that housing prices have fallen and specifically the price of this particular borrower’s house has fallen. One way to try to keep the home is to refinance the mortgage hopefully to lower monthly payments. But if the current mortgage, if the amount owed on the current mortgage is more than the house is worth, lenders are not going to refinance this mortgage.
Stephanie Kelton: When you pay your mortgage, you’re paying off a loan that is equivalent to the purchase price of your home, which may not be what your home is worth today. Hopefully, a home is worth more than the value of the loan, but in some cases it’s worth less. If you refinance, you replace your original loan with a new loan and that can have a variety of benefits like lowering your monthly payment, but if your home is worth less than the amount you owe on your mortgage, lenders won’t refinance the loan. So if you’ve been struggling to pay your mortgage, there will be no relief. You’ll be stuck with the payment you can’t afford and a home that’s no longer worth as much as you paid for it.
Patricia McCoy: And so we have our struggling borrower backed into a corner. If the price of his or her house falls, then they may not be able to refinance the house. Then if they still are having trouble making the monthly mortgage payment, they may start missing payments. They may ultimately go in default, and then they’re looking for closure in the eye. So that’s the risk of a zero down payment loan. There’s no equity buffer in case housing prices fall. Now, let me also mention that right now we are seeing housing prices fall. We appear to have hit a high in many markets in the United States this spring. And now as the Fed is raising interest rates, interest rates are going up on mortgages, fewer people are able to qualify for loans. And in response, housing prices are starting to go down. So this is a very real concern today.
Stephanie Kelton: While there are some risks, zero down payment loans can potentially help people who might otherwise never have the option to buy. And the Bank of America pilot does attempt to provide an equity buffer or protection for buyers should housing prices fall. According to a spokesperson, Bank of America is providing non-repayable down payment grants to give buyers immediate equity in a home.
Patricia McCoy: The zero down payment mortgage is extremely important to expanding home ownership to buyers of color, and I do not by any means take the position that these mortgages should not be made. But I do think it’s very important to think carefully about other ways to offset the risk of these mortgages. So first of all, we want to think about the right loan product. I strongly would recommend a fixed rate mortgage because the principle and interest payments will never go up on these loans. They are the safest mortgages for borrowers who have a zero down payment product.
Stephanie Kelton: A fixed market rate loan is the only product available in Bank of America’s zero down payment program, but it’s not just a question of securing the right mortgage.
Patricia McCoy: We also want to think about the right home. We want to make sure that our borrower is not overstretched buying a larger house than he or she can afford, and we want to think about options like condos that might be more affordable or local subsidized housing purchase options that might make the monthly payments more manageable.
Finally, we want to make sure that before our borrower makes the final decision whether to go into this loan that they’ve had home ownership counseling. We have a wonderful thing in this country, which is that the federal government trains and certifies housing counselors all over the country to provide this type of housing ownership counseling and it’s free. If you go to what we call a HUD certified home ownership counselor, they will provide this counseling for free. Bank of America is requiring it for this particular Bank of America’s zero down payment product, which I’m very glad to hear.
Stephanie Kelton: In terms of expanding access to mortgage credit, zero down payment loans aren’t the only new idea in the business.
Patricia McCoy: There are a couple of things I’d like to talk about. The first one is called automated underwriting, and this is the use of statistical models to do a better job of recognizing people who have been overlooked for credit before, but who in fact are good credit risks.
Stephanie Kelton: Underwriting in this case is the evaluation of a borrower’s loan application by a lender. In other words, it’s how creditors evaluate whether or not a debtor is likely to repay a loan. Automated underwriting is underwriting by computer versus by human, and it’s typically a shorter process that requires less documentation.
Patricia McCoy: Automated underwriting has been around for about 20 years. It has improved significantly. And if it’s used responsibly, it can be very effective in sweeping more people of color into home ownership and making that experience successful for them. I will say that there have been some new concerns about incorporating big data, things like our internet search patterns, into these automated underwriting models. So I want to emphasize that it’s very important to consider whether new forms of discrimination are being conducted through these automated models and to weed that out. But if the automated models are handled responsibly, they should do a good job of identifying promising new borrowers.
Stephanie Kelton: Another new idea, alternative credit scores.
Patricia McCoy: Credit scores have been another obstacle for many home borrower of color. Because on average, credit scores are lower for black and Hispanic home buyers. A lot of that is due to the lingering legacy of housing discrimination in the past. Some very good pioneers have come up with alternative credit score models that would base credit scores on rent payments, utility payments, and car insurance payments, things that are not looked at in traditional credit scoring models. And for families who are renters who make on-time rent payments, on-time utility payments, and on-time car insurance payments, switching to these alternative credit score models could really expand the number of people who are qualified for home ownership and for mortgages.
Stephanie Kelton: Opening up access to home ownership seems like a good idea, but is expanding access to mortgage credit responsible and what are the potential pitfalls? That’s up next after the break.
Welcome back to the Best New Ideas in Money. I’m Stephanie Kelton. Before the break, Patricia McCoy, a professor of law at Boston College Law School, talked about Bank of America’s new zero down payment pilot, as well as two other new ideas, automated underwriting and alternative credit scores. All of these aim to expand access to mortgage credit and thus home ownership. But expanding access to mortgage credit isn’t without risk for borrowers, lenders, and the economy at large. Here’s Patricia McCoy.
Patricia McCoy: Some methods for qualifying more applicants for mortgages come with an elevated default risk, and we saw that with the interest only mortgages, with the pay option mortgages, and with the teaser rate adjustable rate mortgages leading up to 2008. And we also not only saw, but we lived the economic toll that these types of mortgages can reek, if they get out of control and lead to a tsunami of mortgage defaults. The consequences are not just to the borrowers and not just to the lenders, but unfortunately are transmitted throughout the economy, leading to the Great Recession of 2008 in our most recent experience.
Stephanie Kelton: As McCoy sees it, the nature of the housing market itself incentivizes lenders to qualify more borrowers.
Patricia McCoy: As houses become more and more expensive, it is harder to qualify home buyers for mortgages because they’re going to need a higher purchase price that will drive up their monthly payment and their income may not have kept up with the rise in home prices. And so we see during these periods of home price appreciation that lenders are tempted to revert to these more exotic mortgage features in order to qualify more borrowers. We certainly saw that leading up to 2008. It was a disastrous experiment. We’re seeing a little bit of that right now.
One type of exotic mortgage, the interest only mortgage, is making a reappearance. And another type, which is an adjustable rate mortgage in which the initial interest rate is artificially low for a certain period of time, after which the interest rate will go up and so will the monthly payments. That is making it a reappearance too. So I have some worry about these types of mortgages. They have much higher default rates. They are intrinsically risky mortgages and people need to be very, very careful in thinking about whether they’ll take them out.
Stephanie Kelton: That said, important safeguards were put in place in the aftermath of the 2008 crisis.
Patricia McCoy: Today, all lenders are required to make a reasonable and good faith determination that a loan applicant can repay the loan before approving the loan. This regulation has worked pretty well, and so we’re in a much safer place today in terms of safe underwriting loans than we had been. I still however would strongly recommend that anybody who can afford it get a plain vanilla fixed rate mortgage. Your principal and interest will never go up over the life of your loan. If it’s 30 years, it will never go up over 30 years, and that’s a very precious safety feature.
Stephanie Kelton: At the beginning of the episode, we talked about the dream of home ownership and some of the obstacles. We asked McCoy about the nation’s 44 million households who rent. Many if not most renters, have recently faced rising rents. In August, the median monthly asking rent in the United States reached $2,039 according to Redfin data. What advice does McCoy have for those of us who rent?
Patricia McCoy: This is a big challenge for our society, but it’s not one that lacks solutions. So first of all, I would recommend to renters first think about is this the right time in your life to buy? Are you otherwise on firm financial footing? Are you able to save a little bit? Secondly, are mortgage payments the size of or less than your rent payment? If they are, then you very well may want to switch into home ownership. Third thing that I spoke about before is that there are zero down payment programs probably in your community. If you go to one of these HUD certified homeowner counselors, they can help you identify those programs and hopefully get you qualified for a program, especially programs for first time home buyers that will enable you to get a mortgage without a down payment.
Stephanie Kelton: But even if you don’t qualify for a program that enables you to get a zero down payment or low down payment mortgage, a mortgage might not be as far out of reach as you’d think. According to data collected by the National Association of Realtors since 2018, the typical down payment for first time buyers is often as low as six or 7%, much lower than the percent most home buyers assume they’ll need. The same survey found that nearly half of respondents believe they needed to save for a down payment amounting to at least 16% of the cost of a home. Although home prices have begun to drop in many markets, they remain high. And on top of that, interest rates are rising. But in this case, it’s worth considering the bigger picture. Even though rates are rising and they probably won’t feel low if you’re a first time home buyer today, they are a lot lower compared to what many people paid in previous decades. Here’s Patricia McCoy.
Patricia McCoy: When I got my first mortgage in 1989, I think that to qualify for the mortgage, I looked at this just full rate product and the initial rate was 8.5% And the maximum lifetime rate was 11.5%. So to put that into perspective, I think prime mortgage rates today on a fixed rate mortgage are around 6.75%. We are still historically on the lower end of where rates have been historically. That said, everything’s relative. And today the average purchase price on a house, even inflation adjusted, is much costlier than it was in the 1980s. The average square footage of a house is much bigger, and so both of those things push up the monthly payment for people compared to the 1980s. We’ve gotten spoiled by historically low interest rates as of through about a year ago. And so to have those interest rates more than double does make it a lot harder for people to manage the monthly payment because they’re bigger and to get approved for the mortgage in the first place. It’s a real challenge.
Stephanie Kelton: It seems fairly likely that we’ll be seeing a lot of stories about housing over the next few months and into 2023. What will McCoy be watching?
Patricia McCoy: I am watching for stories about this tension between access to credit and access to home ownership on the one hand and default rates on the other. I certainly think as we see mortgage rates going up, that fewer and fewer people of all races and all ethnicities will be qualifying for mortgages, and so there’s going to be a severe dent on access to credit. At the same time, knock on wood, right now our economy still seems to be robust. Hiring is continuing a pace, but if we tip over into a recession due to rising interest rates, what I fear is growing unemployment and that then could open the door to rising defaults on home mortgages that have already been made. So I think we’re at a critical time. Hopefully, we will not tip into a recession, but there is an elevated danger of that and that would almost certainly lead to higher home mortgage defaults.
Stephanie Kelton: While there are new ideas worth considering for McCoy, the best idea may be the one that’s been around for a while.
Patricia McCoy: The fixed rate mortgage is your friend and it has this beautiful silver lining, which is that as your income goes up, as I hope it does for everybody listening to this podcast over time, that your mortgage payment will feel cheaper and cheaper with each passing year. And that is a beautiful thing.
Stephanie Kelton: Thanks for listening to the Best New Ideas in Money. You can subscribe to the show wherever you listen to podcasts, and if you like what you heard, please leave us a rating or review. And if you have ideas for future episodes, drop us a line at firstname.lastname@example.org. Thanks to Patricia McCoy. To learn more about housing and mortgages, head to marketwatch.com. The Best New Ideas in Money is a podcast for Market Watch. Melissa Haggerty is the executive producer and the producers are (inaudible), Katie Ferguson, and Michael McDowell. Editing and mixing by Veronica Simonetti. Jeremy Banks is our news editor and Tim Roston is the executive editor for Market Watch. The Best New Ideas in Money Theme was composed by Sam Retzer. I’m Stephanie Kelton. I’m an economist and a professor of economics and public policy at Stonybrook University and not part of the Market Watch Newsroom. We’ll be back next week with another new idea.