How government policy and markets benefit homeowners

I had a long conversation last night with a friend regarding why she should buy a house. Obviously everyone's situation is different, but I want to list out a number of deliberate U.S. policy decisions that make homebuying advantageous for people with steady jobs.

The U.S. established the Federal National Mortgage Association (FNMA, colloquially known as Fannie Mae) in 1938 to support liquidity conditions in the mortgage market regardless of the prevailing economic situation (at that time, the Great Depression). To me, the existence of agencies like FNMA has always been a sign that subsidizing homeownership--in other words, making it cheaper than it otherwise would be absent government policy--is baked deep into the U.S. government's DNA. They want you to buy a house, and have figured out a bunch of incentives for you to do so. So what are those incentives? I see five.

1. Mortgage debt is non-recourse in the United States. "Non-recourse debt" means that if a borrower fails to make payments on the loan, or defaults on the loan, the lender cannot claim against the borrower's other assets. If you can't make your mortgage payments, the bank can't take your brokerage account, your child's college savings fund, your car, or your Pokemon collection. They only thing the bank can do is repossess the house and kick you out.

Now this might sound bad, but think about it this way. Let's say you buy a house for $500,000, putting 20% down in cash, or $100,000, and borrowing the remaining 80%, or $400,000. Let's further say that few months after buying the house, there's a big real estate crash similar to 2008, and home prices fall 30%. That house is now worth only $350,000--but you still owe $400,000 on the mortgage!

At this point, you have the option to walk away from the house entirely if you want to. Yes, you're out the $100,000 you put in as your down payment--that's your equity. If the mortgage was recourse debt, the bank would be able to go and take $50,000 out of your other assets to make itself whole. But the bank can't do that! The fact that your downside risk in the house is limited to the down payment is a big advantage.

Now, even in 2008, most people didn't walk away from their houses when home prices declined because the declines were not quite as severe as 30% in most metro areas. When I was a consultant to one of the big 4 U.S. banks in 2009/2010, we observed that homeowners walking away generally accelerated when home loan-to-value (LTV) ratios went above 105%. In the above example, with a loan of $400,000 against a home value of $350,000, the borrower would have been highly likely to walk away.

2. Mortgage interest is tax-deductible. This is not as big of a deal as it used to be, as the Trump tax cuts in 2017 changed the rules for how this tax deduction works. I'm including it here for completeness, even though it won't apply to most people, in part because mortgage tax deductions are politically popular and it's entirely possible that Congress could revert to the old version at some point in the future.

In a nutshell, anything you pay in interest on a mortgage up to $750,000 is deductible from your top-line tax liability. Due to amortization, the interest share of your monthly mortgage payment changes over time, so this deduction is more valuable the more recently you bought your home. But if you qualify for it, it effectively works like having a lower interest rate on the mortgage itself (another subsidy). Contrast that with rent, an after-tax expense. If your rent and mortgage would be the same for an equal-size property (we'll discuss price-to-rent ratios in a later post), all else equal, it's better to have a mortgage and have part of the cost offset through the tax deduction.

3. 30-year, fixed-rate mortgages are the standard product. This product offers three advantages that are sometimes hard to find in loan products:

A. A very long term. It's very hard to borrow funds for a 30-year period as an individual; student loans are the only other product where it's commonly possible to get an extremely long loan period. This is because the higher the loan period, the higher the inherent risk to the lender. If I borrow $100 from you, and promise to pay you tomorrow, that's much lower risk to you than if I promise to pay that $100 back in 30 years. A lot can go wrong in 30 years. In order to compensate for this risk, lenders will charge higher interest rates on longer-term loans.

B. Fixed interest rates. Thanks to fixed rates, you can lock in your monthly payments with certainty. Moreover, if interest rates go up, you still have your mortgage at its original note rate--meaning, you are borrowing more cheaply than the market.

C. Prepayment option. What if interest rates go down? In this case, you can refinance your mortgage and capture the new, lower interest rate. This option to refinance (or prepay) is known as the "prepayment option," and allows borrowers to adjust their borrowing strategy in response to changing financial conditions. In a way, you get the best of both worlds--you're protected if rates go up, and if rates go down, you can just get a new, cheaper mortgage.

4. Government insurance. As noted above, the features of fixed rates, prepayment options, and long repayment terms are hard to find in other types of personal loans. Why do banks offer these generous terms for home purchase, but not other types of borrowing? The reason is that these attractive terms are only made possible behind the scenes thanks to government subsidies, protection, and insurance.

Today, the large quasi-government agencies--Fannie Mae and Freddie Mac (known as the GSEs)--function as insurance companies. Any mortgage loan made according to GSE guidelines, called "conforming mortgages," is guaranteed by the GSEs, meaning that if the borrower fails to pay, Fannie or Freddie will step in and take over the loan, making the lender whole. This means that a great deal of the uncertainty of making a loan for 30 years, or making a fixed-rate loan, is taken out of the process from the lender's perspective, making them willing to lend more cheaply than they otherwise would. You do pay for this insurance, but the cost on an individual mortgage is relatively small. You are mostly paying for it through the government as a taxpayer.

5. Leverage. Leverage in this context just means that you are able to buy an asset using someone else's money. With houses, you can buy a house with 80% of the purchase price coming from someone else, but if home prices go up, you capture all of the price appreciation. The downside is that if home prices go down (as they did in 2008) you eat all of the losses. So don't buy at the peak of a bubble. But if you're in a strong real estate market, with solid population and job growth, you're likely to eventually come out ahead on a home purchase, particularly if you are living there (since you have shelter expenses anyway).

There's a saying, all great fortunes are made with leverage.


All these factors taken together sum up to a significant pile of legal and financial advantages to buying property.

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