It is ironic in the extreme that the area of life with the greatest affordability concerns—housing—is also the one with the most government support. Washington and most states offer generous tax benefits to mortgage borrowers, and two huge government corporations—the Federal National Mortgage Corporation (FNMA), colloquially called Fannie Mae, and the Federal Home Loan Mortgage Corporation (FHLMC), colloquially called Freddie Mac—channel trillions to help finance home ownership. Yet housing supplies remain inadequate, especially at the lower end of the price distribution, and a recent Gallup poll shows that almost half those who do not already own a home believe they will never afford one, at least not any time soon. An explanation of the housing affordability problem would require a complex of considerations, but most revealing is the counterproductive aspects of all this government help.
How the Mortgage Interest Tax Deduction Works Against Buyers
Exhibit one: the income tax deduction for mortgage interest payments. The break aims to support home ownership and was originally put into effect in 1913, when the Constitution was amended to allow the federal government to levy income taxes. As it stands today, a couple can write the interest on up to $750,000 in mortgage debt ($375,000 of a single filer) off their taxable income. While this break indirectly penalizes those who do not carry a home mortgage by implicitly asking them to make up in their taxes the federal revenues foregone by this break, this seeming benefit does less to support homeownership than it seems, especially for the first-time homebuyer.
Why the Tax Break Inflates Home Prices
Part of the problem is that markets price the break into both the purchase price of a house and the financing rates lenders charge, making each higher than it would be otherwise. It would take a bigger computer model of the economy than this writer has at hand to make precise estimates, but a few simple calculations can give an idea.
At the very least, buyers would bid up the home’s price by the amount of their tax savings. This is no small figure. A 30-year mortgage today carries a rate of 6.7%, which on the maximum $750,000 mortgage, would allow the owner to write $50,250 off his or her taxable income each year. At the maximum federal income tax rate of 37%, that would be worth $18,593 in tax savings. Since the average price of a home in the United States today is about $503,000, this one consideration implies that in the absence of the tax break the price would be closer to $483,000. It is not a huge difference, but not insignificant either. And because the tax benefit would accrue every year for many years, the price effect would probably be greater. Of course, this calculation applies to the high end. Lower mortgage sizes and lower tax rates would reduce the impact, but there would be one, nonetheless.
Something similar happens with mortgage rates. Because borrowers can deduct some or all the cost of financing, lenders are able to charge a higher figure than they otherwise could. This effect shows in the spread between the rate on a 30-year treasury bond and the rate on an average 30-year mortgage. Presently it amounts to about 2 full percentage points. Much of this gap, of course, reflects credit risk. Even the most credit worthy mortgagee has a higher default risk than the U.S. Treasury. Such credit considerations have not changed much over time, but that gap has widened nonetheless by almost a third from 2019 when the gap was 1.6 percentage points. Certainly, a part of this additional premium reflects how the 60% rise in home prices since 2019 has enhanced the rising value of the tax write off.
It would seem then that the tax break on mortgage interest has done more to help established (Boomer) homeowners with higher incomes than lower-income aspiring home buyers. But this is not the only problem attached to government support for home ownership. The other revolves around regulatory rigidities and the unintended consequences of financial legislation.
Dodd-Frank and the Rise of Fannie Mae and Freddie Mac
The Dodd-Frank Financial Reform Act of 2010 has had influence. It aimed to avoid the financial catastrophe of 2008 by imposing stricter capital requirements and liability limits on financial institutions. These otherwise well-meaning changes all but killed the willingness of banks and like lenders to keep mortgages in their balance sheets. Into the breech stepped Fannie Mae and Freddie Mac as well as the Federal Housing Administration and Veterans Affairs lending. These entities bought the unwanted mortgages from the lenders, bundled them into securities, and sold them to investors on bond markets. Fannie and Freddie have as a consequence become increasingly dominant, involved now in some 60% of the mortgages outstanding in the United States, up from the 45% just before the crash in 2008. Add the two other government entities and the government is now involved in 85% of all mortgages.
How Government Dominance Has Made Mortgages More Rigid
Concentration like this always raises red flags. Markets work most effectively when there is a diversity of buyers and sellers (Diversity, as the saying goes, is very much their strength). And the dominance of the government structures has rendered the world of mortgages more rigid and standardized than ever and so less able to accommodate change. Because just about all transactions today accommodate Fannie and Freddie structures and procedures, neither borrowers nor lenders can work out alternative arrangements that otherwise might suit their individual needs and facilitate what might be characterized as a constellation of particularized arrangements.
Take, for example, the nation’s need for an inter-generational transfer of the existing housing stock. It was once thought that the huge baby-boom generation would downsize after retirement and open up a stock of homes too large for them but suitable to young, growing families. But because these existing homeowners acquired their mortgage at lower rates than today, they are reluctant to sell and accordingly remain in these large empty nests. An arrangement that would allow them to move all or part of their existing low-rate mortgage to another dwelling, even if fees were imposed, would certainly facilitate this process. Such arrangements have been developed in other countries, the United Kingdom, Canada, and Australia most noticeably, but because they run afoul of existing Fannie, Freddie, etc. rules, they have no place in the United States. Similarly, today’s rigid arrangements have denied the mortgage market a number of adjustable-rate options and equity-sharing arrangements that might facilitate purchases by others presently trapped in rentals.
Nothing here suggests that these policy impositions are all that there is in today’s housing affordability problem. Neither is there an implication here that Boomers have intentionally victimized the Millennial and Gen Z generations; nor that Washington has intentionally done so. On the contrary, all has emerged from the best of intentions. Results, however, are better than intentions.
