Feature
by Harvard University's Joint Center for Housing Studies
Editor’s note: Harvard University assesses housing trends nationwide and releases an annual overview of its findings. San Francisco Apartment Magazine will serialize this year’s report over the next few months.
After 12 successive years of increases, the national homeownership rate slipped to 68.9% last year. This small dip reflects, in part, the sharp swing in renter households, whose numbers fell by a half-million in 2004 and then surged by more than a half-million in 2005. Even so, the number of homeowners increased by nearly one million last year as solid job gains and rapid house-price appreciation brought buyers to the market.
Buoyed by demand for investment properties and second homes, home sales hit a new peak before softening in the latter part of the year. As sales slowed in many areas, the supply of homes on the market increased. Although not yet creating a buyer’s market in most places, the backlog was enough to slow the rate of house-price appreciation in a slim majority of metropolitan areas in the second half of 2005.
Lasting Gains
While topping out nationally, homeownership rates in some regions and among some groups continued to rise last year. Thanks in part to underwriting systems that relieve downpayment constraints and new mortgage products that lower initial monthly payments, homeownership rates increased modestly in the Northeast and West as buyers rushed to take part in hot markets. In fact, the homeownership rate of households under the age of 40—the group most likely to be deterred by higher interest rates and house prices—edged up 0.1 percentage point.
More importantly, the boom that began in 1993 puts households in their 20s and 30s (the echo boomers and the baby-bust generation) on a distinctly higher homeownership trajectory than previous generations. While homeownership rates have gone up across the board, younger and minority households have made the largest percentage-point gains.
Accounting for nearly two-thirds of household growth in 1995–2005, minorities contributed 49% of the 12.5 million increase in homeowners over the decade. But even with these strong numerical gains, increases in homeownership rates of minorities barely exceeded those of whites. As a result, the gap between white and minority rates remains near 25 percentage points.
In large measure, the stubbornly wide homeownership gap reflects the rapid growth in young minority households. Because young households have lower homeownership rates than older households, they bring down the overall rate for minorities. Part of the disparity in rates also reflects the fact that minorities continue to lag behind whites in average income. Indeed, the lower average incomes and ages of minorities together account for about 15 percentage points of the gap in the homeownership rates.
Second-Home Demand
While available statistics provide inconsistent estimates, ownership of second homes is clearly on the rise. The Housing Vacancy Survey puts the growth in second homes between 1995 and 2005 at 22%—a 1.2 million increase in just ten years. The American Housing Survey places the rise in second-home ownership at a smaller but still substantial 620,000 over the ten years between 1993 and 2003.
Similarly, the shares of homeowners in all age groups who reported owning a seasonal/vacation home or timeshare were also up in the Survey of Consumer Finances. The increases reported in second-home shares, however, are concentrated entirely among fractional timeshare owners for all age groups except those now in their 60s.
But actual second-home shares are likely higher than these numbers suggest because the survey does not ask about properties owned for occasional use (other than of a seasonal/vacation nature). Many owners have second homes that they use mostly on weekends or for work reasons. Indeed, only 56% of all second homes reported in the Housing Vacancy Survey are for seasonal use.
Home equity growth and lower interest rates are certainly part of the explanation for the surge in second-home ownership. The trend toward later retirement as well as increases in other sources of household wealth—including stocks, bonds and inheritances—have also helped. Moreover, the tax law changes of 1997, which excluded realized capital gains from the sale of homes of up to $500,000, reduced the incentive for sellers to reinvest in more expensive primary residences. Many households likely applied some of this cash to second-home purchases.
Looking ahead, the number of second homes should continue to increase, even if age-specific second-home ownership rates do not. The movement of the baby boomers into their 50s and 60s—the ages when households are the most likely to own additional homes—helps to ensure healthy growth in second-home ownership between now and 2015.
Eroding Affordability
House prices continued their dazzling ascent in 2005, climbing well ahead of household income and general price inflation. Until the end of 2003, falling interest rates offset escalating prices to keep homebuying affordable in many metropolitan areas. But with both short- and long-term rates climbing thereafter, the monthly mortgage payment on a typical home with a 30-year fixed-rate loan increased by $104 to $1,165 in 2005, while a home with a one-year adjustable loan rose by $148 to $998. For buyers who could not cover the higher downpayment and instead rolled the difference into the mortgage, monthly payments on fixed-rate loans were up by $115 last year.
In the nation’s hottest housing markets, the erosion of affordability has been much more dramatic. In Phoenix, for example, monthly payments on a median-priced home jumped from $930 in 2003 to $1,017 in 2004 and to $1,316 in 2005—even for homebuyers who were able to cover the increasingly large 10% downpayment.
Responding to these pressures, growing shares of borrowers turned to adjustable-rate mortgages. After nearly doubling to 35% in 2004, the adjustable-rate share of conventional mortgage originations fell only slightly to 31% in 2005.
Normally, it takes large spreads to encourage borrowers to forgo the protection of fixed-rate mortgages. Yet for part of 2004 and most of 2005, there was almost no difference between fully indexed adjustable rates and fixed rates. Under these conditions, the main appeal of adjustable mortgages is the lower teaser rate offered in the first year or two of the loan. The discounts started at about 0.4 percentage points in 2004, ended the year at about 1.5 percentage points and inched up to about 2.0 percentage points for the rest of 2005.
Adjustable mortgages are also gaining market share because they now feature longer initial fixed rates, allowing borrowers to match the lock-in period to the length of time they plan to stay in their homes. Accordingly, the most popular adjustable loans are “hybrids” with a fixed-rate period of five years. Only about a third of adjustable originations in 2005 had an initial term of one year, down from nearly half in 1999.
Over the course of 2005, fully indexed interest rates on adjustable mortgages increased by about 1.6 percentage points. When added to the expiration of the initial 1.5 percentage-point discount, some adjustable-rate borrowers had to face much higher payments early in 2006. Many lenders do, however, cap the single-year adjustment so that not all borrowers were hit by the full increase.
Still, with short-term interest rates expected to climb again in 2006, a growing number of adjustable-rate borrowers will likely see their payments go up. The Mortgage Bankers Association estimates that adjustable-rate loans now amount to about 25% of total mortgage debt outstanding. The interest rate on about a quarter of this debt has or will reset by the end of 2006. Fortunately, the vast majority of homeowners—including the 75% of mortgage debt holders with fixed-rate loans, plus the nearly one-third without mortgages—will be unaffected by these changes.
Mortgage Product Innovation
To help buyers qualify for mortgages, increasing numbers of lenders now offer a variety of products that lower borrowers’ initial monthly payments. For example, interest-only loans defer principal payments for a set number of years. Payment-option loans defer a portion of the interest payments and roll the difference into the principal. Low-documentation loans let borrowers with erratic or hard-to-document resources provide limited details about their income and assets.
Despite the novelty of these products, many consumers have been attracted by their flexibility. LoanPerformance, a real-estate data company, estimates that, from almost zero in 2003, interest-only loans accounted for 20% of all mortgage originations by the second half of 2005, with 37% of adjustable-rate loan originations and 5% of fixed-rate loan originations interest only. At the same time, payment-option mortgages reached 10% of originations by year-end, and low-documentation loans hit 12% in the second half of 2005. Although they amount to only a small share of all homeowners, about 3 million borrowers have interest-only adjustable loans and 1 million have payment-option first mortgages.
While all homeowners with interest-only loans must begin to pay principal at the end of the agreed-upon period, those with adjustable loans may also get hit with higher interest rates when the initial fixed-rate period ends. Together, these effects can drive monthly payments up sharply. Most interest-only adjustable loans do, however, have interest-only periods of at least five years, allowing time for a borrower’s income to increase or the household to move before the principal payments are due. Indeed, about one in eight homebuyers relocate within three years of buying their homes, and one in three relocate within five years. Some home loans also have fixed-rate and interest-only periods whose termination dates do not coincide, thereby preventing both rate adjustments from occurring at the same time.
Subprime Lending Growth
Along with the market for innovative loan products, the volume of subprime loans has grown dramatically from just $210 billion in 2001 to $625 billion in 2005 in real terms. Last year’s total represents 20% of the dollar value of loan originations and about 7% of mortgage debt outstanding.
Subprime lending has helped millions of Americans with blemished credit histories buy homes or tap into their housing wealth at a time when strong price appreciation has lifted their home equity. In fact, LoanPerformance reports that almost 6 million homeowners now have subprime first-lien mortgages. Without the sudden expansion of subprime lending, most of these homeowners would have been denied access to credit.
But subprime loans typically have special terms and higher rates to cover the higher expected default rates. At 6% in the fourth quarter of 2005, the share of subprime loans at least 60 days delinquent or in foreclosure was seven times that of prime loans. Moreover, the concentration of subprime loans in low-income minority neighborhoods puts some of these communities at risk of widespread foreclosures.
Mounting FHA Risk
Prime and subprime lenders are now competing successfully for borrowers that previously qualified only for Federal Housing Administration-insured loans. As a result, FHA is losing much of its traditional base of first-time and minority homebuyers to lenders able to offer better deals. The net effect is that FHA currently holds a significantly smaller market share that is made up of riskier loans. Today, delinquency rates on FHA loans exceed those on subprime loans.
Unlike subprime lenders that engage in risk-based pricing, FHA charges a single average price and imposes a flat 1.5 percentage point upfront premium for mortgage insurance, as well as a 0.5 percentage-point recurring premium. Although FHA continues to take in more in premiums than it pays out in claims, concerns are mounting about the stability of this 70-year-old insurance program. Moreover, the pressures on FHA’s credit quality are probably here to stay, given the ability of both prime and subprime lenders to use automated underwriting and risk-rating technology to compete on price for less risky borrowers in FHA’s traditional markets.
Still, FHA remains a critical resource in many underserved areas and may again be called upon to stabilize housing markets in the event of a sharp regional downturn. Indeed, when the oil boom went bust and the savings and loan industry collapsed in Texas in the 1980s, FHA became the insurer of last resort and staved off a potentially harsher correction in the state.
Home Equity Gains
Having significant home equity is the best protection against foreclosure because homeowners can sell at a profit if they cannot cover their mortgage payments. Even with the massive cash-outs over the past several years, home equity still amounts to about 56% of the aggregate value of primary residences. At last measure in 2004, escalating home prices had shored up the wealth of most homeowners, with 94% having equity of 10% or more and 87% having equity of 20% or more. Only 3% of homeowners had equity stakes of less than 5%. Nevertheless, some 7% of non-elderly low-income homeowners have such small equity stakes.
With homeownership the cornerstone of household wealth in America, the wealth gap between owners and renters is enormous. Among those under age 40 with incomes in the $20,000–$50,000 range, owners have 10 times the median net wealth of renters. Fully half of their $45,640 net wealth is in the form of home equity. Among households in their 40s and 50s with incomes in that same range, the discrepancy is even bigger—$88,000 versus $6,430—with home equity again contributing half of owners’ wealth.
The Outlook
The gains of the last ten years have lifted homeownership growth to a higher trajectory. Remaining on this path depends on whether the recent conditions that have strongly favored homeownership can continue.
A major reason for the recent climb in homeownership is that house-price appreciation has been unusually strong over the past five years. In addition, long-term interest rates have remained at historic lows even as short-term rates have returned to more normal levels. If the economy picks up steam, interest rates are likely to increase and the growing share of households with adjustable-rate mortgages will find themselves with rising payments. Interest-only borrowers who do not sell their homes or refinance before principal payments come due will also get hit by much higher payments. Already though, an increasing number of borrowers have refinanced their adjustable loans.
If the economy instead stumbles and job growth falters, a larger number of subprime borrowers will be at greater risk. At the same time, however, the lower interest rates that usually accompany such slowdowns would help adjustable-rate borrowers and create opportunities for other homeowners to refinance their loans on more favorable terms.
Next month: The December issue will feature part five of the series, “Rental Housing.”
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or San Francisco Apartment Magazine. Reprinted from the State of the Nation’s Housing 2006 with permission from the Joint Center for Housing Studies of Harvard University. To read the complete report, please visit the Joint Center’s website at www.jchs.harvard.edu. All rights reserved.