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Our Single Most Egregious Mistake in How We Finance Real Estate

The ability for Americans to buy a home is a critical cog in the wheel of our economy. As a nation, we've benefitted greatly from securitization, whether via HUD, FNMA, or nonconforming MBS, as such programs enable the purchase of a home with a relatively small down payment and a reasonable interest rate. If you contrast the lending parameters of such programs to the lending parameters in nations that do not have securitization, you'll find down payments of 25 - 40% along with double digit interest rates because their lenders have to hold a mortgage for the full term of the loan.

The point is that the ability to buy a home is directly tied to the lending parameters available. But there is a flip side to this fact - the price of housing is also tied to lending parameters. This was illustrated in the crisis of 2008 when teaser rates led to more people buying homes than could afford them. Housing prices skyrocketed, which lead to an inevitable correction. Then, when regulators pushed for more conservative lending parameters than necessary, prices fell below the level they should have been, which only exacerbated the magnitude of the crisis.

This gets to the greatest error that we've made in home lending over the past forty years. Lending parameters, especially the qualifying ratios, should not be static in times of falling interest rates! Why not? Because if qualifying ratios are static, people can qualify for higher loan amounts when rates fall, which causes home prices to automatically increase when rates fall.

This is not a revelation to anyone familiar to the real estate market, but the devastating truth behind what it means is not commonly understood. While some may celebrate rising home values, is it really a good thing? The answer is not at all!

For the owner of a home, the sale of an appreciated property only means that they'll have to pay more for their next property. For the new home buyer, rising prices means that buying their first home will be all the more expensive. The only potential winner is someone exiting the market for good. But even they don't take the money with them when they die! So there are no real winners with escalating home prices.

The solution to this problem and what it could mean in terms of our standard of living is remarkable. The promise of true progress is that we get more for less over time. At one time the vast majority of the population had to spend most of their time growing food. Technology freed us of that burden and now only a small fraction of the population is able to produce all the food we need. In other words, today only a small portion of our work week is necessary for obtaining the food we need. Thus, the relative cost of food has dropped over time.

The convention for underwriting a home mortgage is for the homebuyer to spend about 33% of their income on their monthly mortgage payment. If we'd been smart we would have reduced that percentage as rates fell. That would have kept home prices stable and today we could have been spending just 20% of our income on our mortgage payment!

It's not too late to implement such a strategy. I describe one such strategy for both reducing interest rates as well as the percentage of our income we'd have to spend on housing in this excerpt from my book The Emerging Kingdom.


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