Improving Housing Finance in an Inflationary Environment: Alternative Residential Mortgage Instruments

Abstract

Alternative mortgage instruments are mortgage plans designed to accommodate better than traditional mortgages the current needs of residential mortgage borrowers, mortgage lenders, or both. The long-term fixed-rate, fixed-payment mortgage became the prevalent type in the United States in the 1930s and served both borrowers and lenders well as long as price and interest rate movements were relatively small. But recent increases in the level and volatility of market interest rates have made this mortgage contract less desirable to lender and borrower alike. A home is the largest single purchase that most Americans make and the largest single item in their wealth portfolio. Because of the magnitude of the expense—generally some two to three times the purchaser's annual income—a large portion of the purchase price of most homes is borrowed. The owner's downpayment, which represents the initial equity, is generally only 10 to 30 percent of the purchase price. As a result, the cost, terms, and availability of mortgage credit are an important part of the home purchase decision. In recent years the cost of obtaining mortgage credit has increased sharply. For example, in 1971 the average interest rate on a 30-year single-family fixed-coupon, fixedpayment mortgage with a loan-to-value ratio of 90 percent was about 7 3/4 percent. In 1975 the rate on this mortgage had climbed to 9 percent, and in 1980 it reached 12 1/2 percent. On a 90 percent fixed-rate, fixed-payment mortgage on a median price home of $24,800 in 1971, this represented monthly payments of $160. The payments on a new mortgage on a home of the same price would have increased to $182 in 1975 and $238 in 1980. But the median price of existing homes also increased, from $24,800 in 1971 to $62,200 in 1980. Thus, a rate of 121/2 percent on a 90 percent fixed-rate, fixed-payment mortgage of $55,980 translates into monthly payments of $597. Monthly payments have increased considerably faster than household income. In 1971 the annual sum of monthly payments was equal to 19 percent of the median family income of $10,285. In 1980 this percentage had almost doubled to 34 percent of an estimated median family income of $21,652. 1 Some households found this percentage too high to pay and, as a result, decided not to purchase a house. Because most homebuyers are already housed and will sell their homes when buying another, the higher mortgage rates reduce the turnover of existing homes and thus labor mobility, but have relatively little effect on the overall stock of housing. The demand for newly constructed housing is more severely impacted, but it accounts for only a small proportion of total housing. In the 1970s the average 1.7 million new units constructed annually accounted for only about 2.2 percent of the total housing stock of some 79 million units. The heaviest burden of the increase in mortgage payments falls on first-time home buyers, who did not share in the rapid appreciation in home prices and the permissible tax-free transfer of gains from one home to another, and, in particular, on younger households, whose current incomes tend to be below the average for all households. In addi-