Author Archives: David Reiss

Is The Mortgage Interest Deduction Inequitable?

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photo by Elana Centor

I have certainly thought so, as do many other housing policy types. Daniel Hemel and Kyle Rozema have a more nuanced view in their paper, Inequality and the Mortgage Interest Deduction, that was recently posted to SSRN. The abstract reads,

The mortgage interest deduction is often criticized for contributing to after-tax income inequality. Yet the effects of the mortgage interest deduction on income inequality are more nuanced than the conventional wisdom would suggest. We show that the mortgage interest deduction causes high-income households (i.e., those in the top 10% and top 1%) to bear a larger share of the total tax burden than they would if the deduction were repealed. We further show that the effect of the mortgage interest deduction on income inequality is highly sensitive to the alternative scenario against which the deduction is evaluated. These findings demonstrate that claims about the distributional effects of the mortgage interest deduction depend critically on the counterfactual to which the status quo is compared. We extend our analysis to the deduction for state and local taxes and the charitable contribution deduction. We conclude that the appropriate counterfactual for distributional claims is dependent upon political context — and, in particular, on the feasible set of politically acceptable reforms up for consideration.

To make this a bit more concrete, the authors offer a simple hypothetical:

to show how a provision of the tax code can provide a disproportionate share of dollar benefits to the rich while also causing the rich to bear a larger share of total tax liabilities. Imagine a society with two households—a rich household with pre-tax income of $100, and a poor household with pre-tax income of $50. Further imagine that the rich household pays $12 in mortgage interest and the poor household pays $9 in mortgage interest. Say that the tax system is structured such that the tax rate on the first $50 of income is 20% and the tax rate on all income above the $50 threshold is 40%.

If the tax system does not allow a deduction for mortgage interest, the rich household would pay a tax of $30 ($10 on the first $50 and $20 on the next $50), and the poor household would pay a tax of $10. Thus the government would collect a total of $40 in revenue; the rich household would bear 75% of the total tax burden ($30 divided by $40); and the poor household would bear the remaining 25%. If the tax system allows each household to deduct mortgage interest, the rich household would receive a benefit from the deduction of $4.80 ($12 times 40%), and the poor household would receive a benefit from the deduction of $1.80 ($9 times 20%). The benefit of the MID in dollar terms is clearly greater for the rich household than for the poor household. In percentage terms, the rich household received 72.7% of total MID benefits, while the poor household received 27.3% of total MID benefits. And yet the rich household now bears 75.45% of the total tax burden ($25.20 divided by $33.40), as compared to 75.0% before, while the poor household now bears 24.55% of the total tax burden ($8.20 divided by $33.40), as compared to 25.0% before. (Government revenue decreases from $40 without the MID to $33.40 with the MID.) (8, footnote omitted)

The authors conclude that their analysis “simultaneously confirms and challenges widespread beliefs regarding the effect of tax expenditures on inequality. The mortgage interest deduction does indeed appear to be inequality-increasing relative to a counterfactual in which the deduction is repealed and revenues are reallocated to all households on a equal basis; when the mortgage interest deduction is evaluated against other counterfactuals, however, the distributional effects are more nuanced.” (40)

Where does this leave us? It reminds us that we should be careful about promoting simple policy proposals without taking into account the likely context in which they might be implemented.

Financially Capable Young’uns

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The Consumer Financial Protection Bureau has issued a new model and recommendations, Building Blocks To Help Youth Achieve Financial Capability (link to report at bottom of page). It opens,

To navigate the financial marketplace effectively, adults need financial knowledge and skills, access to resources, and the capacity to apply their money skills and habits to financial decisions. Where and when during childhood and adolescence do people acquire the foundations of financial capability? The Consumer Financial Protection Bureau (CFPB) researched the childhood origins of financial capability and well-being to identify those roots and to find promising practices and strategies to support their development.

This report, “Building blocks to help youth achieve financial capability: A new model and recommendations,” examines “how,” “when,” and “where” youth typically acquire critical attributes, abilities, and opportunities that support the development of adult financial capability and financial well-being. CFPB’s research led to the creation of a developmentally informed, skills-based model. The many organizations and policy leaders working to help the next generation become capable of achieving financial capability can use this new model to shape priorities and strategies. (3, footnotes omitted)

I have been somewhat skeptical of CFPB’s financial literacy initiatives because there is not a lot of evidence about what approaches actually improve financial literacy outcomes. Unfortunately, this report does not reduce my skepticism. While it claims that it is evidence-based, the evidence cited seems scant, as far as I can tell from reviewing the footnotes and appendices.

The report concludes,

Understanding how consumers navigate their financial lives is essential to helping people grow their financial capability over the life cycle. The financial capability developmental model described in this report provides new evidence-based insights and promising strategies for those who are seeking to create and deliver financial education policies and programs.

This research reaffirms that financial capability is not defined solely by one’s command of financial facts but by a broader set of developmental building blocks acquired and honed over time as youth gain experience and encounter new environments. This developmental model points to the importance of policy initiatives and programs that support executive functioning, healthy financial habits and norms, familiarity and comfort with financial facts and concepts, and strong financial research and decision-making skills.

The recommendations provided are intended to suggest actions for a range of entities, including financial education program developers, schools, parents, and policy and community leaders, toward a set of common strategies so that no one practitioner needs to tackle them all.

The CFPB is deeply committed to a vision of an America where everyone has the opportunity to build financial capability. This starts by recognizing that our programs and policies must provide opportunities that help youth acquire all of the building blocks of financial capability: executive function, financial habits and norms, and financial knowledge and decision-making skills. (52)

What the conclusion does not do is identify interventions that actually help people make better financial decisions. I am afraid that this report puts the cart before the horse — we should have a sense of what works before devoting resources to particular courses of action. To be crystal clear, I think teaching financial literacy is great — so long as we know that it works. Until we do, we should not be devoting a lot of resources to the field.

Multifamilies for Retirement Income

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photo by Laurent Montaron

Financial Advisor quoted me in More Retirees Turning To Multifamily Homes For Income. It opens,

Many clients are investing in multifamily residences as a way to generate retirement income.

“A common way for people nearing retirement is to buy a triplex or fourplex, live in one unit and rent out the others,” said Keith Baker, a financial advisor and professor of mortgage banking at North Lake College in Irving, Texas. “They sell their home and use the equity they have built up to do this, and if they still owe some debt, it will be paid down more quickly.” Among the best multifamily properties to acquire for supplemental income is one that has separate entrances with no shared common areas so that each family has their own space, according to Michael Foguth, a financial advisor in Brighton, Michigan.

“Townhomes are very popular,” Foguth told Financial Advisor. “Also popular are duplexes where you have one unit on the ground level and one unit on the second level.”

But clients should not spend so much money to acquire a property that their retirement income ends up undiversified. “If the bulk of your retirement income is tied up in one property, you are exposed to natural disasters like floods as well as economic downturns in that market,” said David Reiss, a professor at Brooklyn Law School who teaches real estate finance.

An alternative to buying a property is modifying an existing residence with the intent of renting out rooms on websites like AirBnB or HomeAway. “You would need to make sure that deed restrictions, zoning and city ordinances allow this,” Baker said. “It also will require property insurance and additional liability coverage.”

When a multifamily rental property is also a primary residence, a portion of the mortgage is tax deductible, according to Carla Dearing, CEO of SUM180, an online financial planning service. There may also be the opportunity to leverage tax benefits like depreciation.

“Selling your home and taking out a loan on a rental four-unit apartment complex allows you to deduct from your income the pro-rated interest expense along with the depreciation expense of the portion of the units you don’t live in so that much of the income is sheltered,” Baker said.

Over time, the income support received from a rental property can be greater than the interest income from investing in the stock market. “You’re likely to receive a nice stream of income when you are renting to people with guaranteed incomes,” said James Brewer, CFP, in Chicago. Nationally, the average price-to-rent ratio is 11.5, meaning that the average property owner is buying a property for a price of 11.5 years worth of rent, which is an estimated 8.7 percent yield on her investment, according to data from Zillow.

A house that cost $200,000 should bring in $1,450 per month in rent using the national price-to-rent average, according to Matt Hylland, an investment advisor with Hylland Capital Management in Virginia Beach. That’s compared to 10-year government bonds, which yield 1.7 percent and the S&P 500 index, which yields about 2 percent.

“But this 8.7 percent is before any costs,” Hylland noted. In other words, clients who add rental property to their portfolios should also add cash to their emergency funds so that have money on hand to maintain and repair the house. “If the roof needs replacing, do you have $5,000 available to fix it?” asks Hylland.

Ideally, a multifamily acquisition will be move-in ready. “Homes that require construction or renovation can easily turn into a money pit, costing twice what you estimate up front,” Dearing said.

Comparing Rental Housing Across the Atlantic

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photo by Tiago Fioreze

The Harvard Joint Center for Housing Studies has released a working paper, Rental Housing: An International Comparison. The abstract reads,

This report compares rental housing in 12 countries in Europe and North America, using individual records from household surveys. Differences in housing characteristics, conditions, and costs across countries reflect a number of factors, including demographics, geography, culture, and government policies. A lack of comparable data can make international comparisons difficult to execute, but such analysis is valuable for understanding and contextualizing differences in affordability and other characteristics of renter households and housing.

The analysis revealed the US, along with Spain, as notably unaffordable for renter households, based on a number of measures. The greater apparent cost burdens reflected a variety of factors, including differences in characteristics of the housing stock and differences in tax burdens, as well as measurement problems.

However, two major influences – differences in the size and availability of housing allowances and the degree of income inequality – emerged as the main drivers of differences in housing affordability. The effects of supply-side factors such as the extent of social housing supply, supply subsidies, and rent controls were unclear, due to problems with the identification and description of below-market rentals in the household survey data. (1)

The housing stock and political context is so different among countries, but this type of analysis is still very useful and can offer valuable lessons to the United States:

One factor that appears to contribute to the pervasive affordability problems in the US is the degree of income inequality. That is not a feature of the housing market per se, but there may be opportunities to address the consequences of income inequality through appropriate housing policies.

Other countries have devoted more resources to ameliorating the problems of unaffordable housing. The US provides fairly generous housing benefits to only a small share of needy households. In the UK, a broadly available system of housing allowances offsets what would otherwise be a much more severe affordability problem than exists in the US. In other countries, affordable rental housing supplied by governments or nonprofits helps to address affordability issues, although the efficiency of that practice, relative to the provision of housing allowances, has been questioned, as it has been in the US. The EU-SILC data used in this analysis did not adequately identify or describe below-market-rate housing, making it impossible to adequately assess the effects of such housing.

The somewhat larger size and perhaps higher quality of units in the US rental stock also affects relative affordability, although relative quality and its effect on cost differences are difficult to assess using the available data. The large share of single-family detached rentals in the US reflects preferences, the demographic mix among renters, land availability, etc., but it could also reflect zoning and other regulations limiting the supply of less expensive multifamily rentals. It is hard to imagine that regulations are more stringent in the US than in some of the more dirigiste nations of Europe, but regulations elsewhere may dictate, rather than constrain, density and cost reductions. The size and quality of the housing occupied by low-income renters in the US reflect the fact that most of those units were originally built for owner occupancy or for higher-income renters. That’s probably true in other countries as well. Whether the extent of such filtering is greater or less in various countries is perhaps worth exploring in the future. (37-38)

Income inequality, housing subsidies and land use reform — the report hits on a trifecta of key issues that housing policy should be dealing with. While I do not see much of an appetite for major reform of the first two items in today’s political climate, there might be support for some loosening of land use restrictions on housing construction. I wonder if there is some room for movement on that third front. Can local jurisdictions be incentivized by the federal government to build more housing?

Subprime v. Non-Prime

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photo by TaxRebate.org.uk

The Kroll Bond Rating Agency has issued an RMBS Research report, Credit Evolution: Non-Prime Isn’t Yesterday’s Subprime. It opens,

Following the private label RMBS market’s peak in 2007 and the ensuing credit crisis, non-agency securitizations of newly originated collateral have focused almost exclusively on prime jumbo loans. This is not surprising given the poor performance of loosely underwritten residential mortgage loans that characterized certain vintages leading up to the crisis. While legacy prime, in absolute terms, performed better than Alt-A and subprime collateral, it was apparent that origination practices had a significant impact on subsequent loan performance across product types.

Many consumers were caught in the ensuing waves of defaults, which marred their borrowing records in a manner that has either barred them from accessing housing credit, or at best made it extremely challenging to obtain a home loan. Others that managed to meet their obligations have been unable to qualify for new loans in the post-crisis era due to tighter credit standards that have been influenced by regulation.

The private label securitization market has not met the needs of these consumers for a number of reasons, including, but not limited to, reputational concerns in the aftermath of the crisis, regulatory costs, investor appetite, and the time needed for borrowers to repair their credit. The tide appears to be turning quickly, however, and Kroll Bond Rating Agency (KBRA) has observed the re-emergence of more than a dozen non-prime mortgage origination programs that intend to use securitization as a funding source. Of these, KBRA is aware of at least four securitization sponsors that have accessed the PLS market across nine issuances, two of which include rated offerings.

Thus far, KBRA has observed that today’s non-prime programs are not a simple rebranding of pre-crisis subprime origination, nor do they signal a return to the documentation excesses associated with “liar loans”. While the asset class is meant to serve those with less pristine credit, and can even have characteristics reminiscent of legacy Alt-A, it is expansive, and underwriting practices have been heavily influenced by today’s consumer-focused regulatory environment and government-sponsored entity (GSE) origination guidelines. In evaluating these new non-prime programs, KBRA believes market participants should consider the following factors:

■ Loans originated under sound compliance with Ability-To-Repay (ATR) rules should outperform 2005-2007 vintage loans with similar credit parameters, including LTV and borrower FICO scores. The ATR rules have resulted in strengthened underwriting, which should bode well for originations across the MBS space. This is particularly true of non-prime loans, where differences in origination practices can have a greater influence on future loan performance.

■ Loans that fail to adhere to GSE guidelines regarding the seasoning of credit dispositions (e.g. bankruptcy, foreclosure, etc.) on a borrower’s credit history should be viewed as having increased credit risk relative to those with similar credit profiles that lack recent disposition activity. This relationship likely depends on, among other things, equity position, current FICO score, and the likelihood that any life events relating to the prior credit issue remain unresolved.

■ Alternative documentation programs need to viewed with skepticism as they relate to the ATR rules, particularly those that serve borrowers with sub-prime credit histories. Although many programs will meet technical requirements for income verification, it is also important to demonstrate good faith in determining a borrower’s ability-to-repay. Failure to do so may not only result in poor credit performance, but increased risk of assignee liability.

■ Investor programs underwritten with reliance on expected rental income and limited documentation may pose more risk relative to fully documented investor loans where the borrower’s income and debt profile are considered, all else equal. (1, footnotes omitted)

I think KBRS is documenting a positive trend: looser credit for those with less-than-prime credit is overdue. I also think that KBRS’ concerns about the development of the non-prime market should be heeded — ensuring that borrowers have the ability to repay their mortgages should be job No. 1 for originators (although it seems ridiculous that one would have to say that). We want a mortgage market that serves everyone who is capable of making their mortgage payments for the long term. These developments in the non-prime market are most welcome and a bit overdue.

What Is a Probate Sale?

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Charles Dickens' Bleak House

Charles Dickens’ Bleak House

Realtor.com quoted me in What Is a Probate Sale? A Home You’ll Have to Win in Court. It opens,

If you’re looking to buy a home on the cheap, you might have stumbled across a probate sale. But what exactly is a probate sale? Basically it means that the homeowner died without a will bequeathing the house to an heir. In most cases, this means that an estate attorney or representative has to sell the property in order to liquidate the asset and distribute the money to family members—and that can spell a major bargain for you.

Probate sales can be attractive to buyers because they’re often priced below their market value, much like foreclosures. But since a court has to supervise and approve the home’s sale, the process is more complicated—and lengthier—than usual.

Here’s a look at the legal hoops you’ll have to jump through to make a probate sale happen.

How A Probate Sale Works

In a probate sale, the estate attorney or other representative hires a real estate agent to post the listing and sell the home. While buyers may be drawn in by the budget-friendly price, probate homes are not for everyone, starting with the fact that the homes are typically sold as is.

“Usually the estate doesn’t have an interest in renovating the property, either because of logistics, timing, or available funds,” says Richard Witt, owner of Long Island Cash Home Buyer. So, don’t expect the estate owners to make any repairs before you move in; what you see is what you get. That said, those in the know advise getting a home inspection just to make sure there aren’t major problems that would deter you from moving forward.

Here’s another difference with probate sales: If you decide to make an offer, that must be accompanied by a deposit totaling 10% of the price of the home. That’s in addition to your down payment, although this deposit can be folded into your down payment if the deal goes through.

Once your offer is accepted by the estate’s representative, that’s not where the negotiations end. From there, the estate attorney has to petition the court to approve the sale. And as you might expect, courts move at their own pace; expect to wait 30 to 45 days (or even longer) for your day in court when you can claim your home.

Playing the waiting game isn’t the only frustrating aspect of probate sales. In certain states, even as your offer is making its way through the courts, the home can remain listed and be open to other bidders who may be allowed to show up at your hearing and outbid your offer.

“In California, for instance, probate homes typically do go up for auction at the courthouse after the offer comes in,” says David Reiss, research director at the Center for Urban Business Entrepreneurship at Brooklyn Law School. “This builds a lot of uncertainty into the process for the bidder who gets the ball rolling in the first place.” All that said, you also have a right to counteroffer and, even if you do lose out, you should at least get your 10% deposit back. 

Down in ARMs

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TheStreet.com quoted me in Top 5 Lowest 7-Year ARM Rates. It opens,

U.S. mortgage rates have continued to decline in the aftermath of the Brexit vote, low Treasury rates and stagnant economy, giving potential homeowners an opportunity to save money because of the dip.

The current market conditions give homeowners in the U.S. an opportunity to take advantage of the continuation of low mortgage rates since the Federal Reserve has not increased interest rates.

But, how do you snag the absolute lowest rates, especially if you don’t plan on staying in your first home for more than seven years and are learning toward 7/1 adjustable rate mortgages (ARMs)?

The 7-year ARMs are attractive to consumers, especially first-time homebuyers, because the interest rates are lower, helping you save more money each month compared to the traditional 30-year mortgage.

“You get what amounts to a fixed rate mortgage, but at a lower rate than the traditional 30-year fixed,” said Greg McBride, chief financial analyst of Bankrate, a North Palm Beach, Fla.-based financial content company.

While lower monthly payments are appealing, the interest rates reset after seven years, and it can be difficult to determine how much they will increase.

“If your timetable changes, then you may want to reconsider the loan you have,” he said. “You don’t want to be in the position of facing rising monthly payments that squeeze your budget or jeopardize your ability to afford your own home.”

Consumers on fixed incomes and saddled with student loans and credit card debt might opt for a 30-year fixed rate mortgage, because it represents “permanent payment affordability,” McBride said. The principal and interest will never change, because it is a fixed rate and can be easier to budget.

“It may not always be the optimal choice, but it is the safest choice,” he said.

Adjustable rate mortgages can still be beneficial if homeowners take advantage of the savings each month and allocate it towards paying down debt or into an emergency fund.

“Even if you’re still holding the 7-year ARM at the end of seven years, that doesn’t automatically turn it into a bad decision,” McBride said. “You will have banked seven years of savings relative to the fixed rate mortgage that can help you absorb any payment increases until you refinance or sell the home.”

Many consumers gravitate toward the 30-year mortgage, because the payments are stable and have been very low, said Jonathan Smoke, chief economist for Realtor.com, a Santa Clara, Calif.-based real estate company. Others are seeking the 7-year ARM, because they are more likely to qualify for a mortgage.

Mortgage activity so far in 2016 reveals that only 3% of mortgages have had shorter rate terms, according to Realtor.com’s analysis of purchase mortgage activity. Hybrid term mortgages such as the 7/1 ARM typically increase in share when “mortgage rates rise because the shorter fixed term offers a lower rate, often between 40 and 100 basis points,” he said. “The lower rate translates into a lower payment for the duration of the initial term, which is seven years.”

Each lender utilizes a benchmark such as a the 10-year U.S. Treasury or LIBOR rate and a margin, which is “what is added to the benchmark to determine your new rate,” Smoke said. The loans also have a cap on how high any single rate change can be and also a ceiling on how high the rate can ever be, he said.

At the end of the seven years, homeowners can choose to refinance to a lower fixed rate, but need to budget for the closing costs.

A lower rate upfront can be favorable for younger homeowners, but examining the ceiling rate and how it will impact your monthly payments is crucial.

“A mortgage broker or lender can help you walk through scenarios to determine if your timeline could benefit,” Smoke said. “To help calm any nerves about just how high your payment could go, ask yourself if you are willing to exchange the initial seven year savings for how long you might keep that mortgage after the seven-year period is up.”

Paying the premium for the peace of mind that your payments will remain static means that if interest rates rise several percentages in the next few years, you won’t be faced with having to consider the lower rate options or lower priced homes and/or more money down, he said.

“That’s why hybrids will likely become more popular in the future compared to how little they are used today,” Smoke said.

Since people have a tendency to change homes every seven years on average, a 7/1 ARM could be a good option because the savings can be substantial, said David Reiss, a law professor at Brooklyn Law School in N.Y.

“Even if you are not planning to move now, the future may bring changes such as divorce, frail relatives, job loss or new job opportunities,” he said. “Some people like the certainty of the 30-year fixed rate mortgages, but it is worth calculating just how much that certainty will cost you.”