Does Homeownership Really Increase Household Liabilities?

The way we think about various assets, costs, and sources of income can be greatly influenced by how we mentally frame them, even when our reactions seem purely empirical.

For instance, because of how they are bought and sold, bonds are usually described in terms of their yields and homes are described in terms of their prices. When market yields decline, the effect on both types of assets will be similar. Yet, that difference in framing leads to a tendency to complain that low bond yields are reducing the incomes of savers while high home prices are providing those same savers with windfall gains. We could just as easily reverse those descriptions.

The way we think about debt and household liabilities also influences the way we frame various economic activities. To illustrate, let’s compare automobile owners to homeowners.

In the automobile market, one can imagine two ends of the spectrum. A buyer with access to credit and a high income will tend to purchase a newer car, in which case, he might have a $700 monthly car payment for a very dependable machine that has a warranty. Or maybe he even leases his car. His monthly payments are high, but predictable.

A buyer with less access to credit and a lower income will probably be limited to used cars. In that case, he may be forced to buy an old car with a monthly payment of only $300. His monthly planned expenses will be much lower, to match his lower income. The problem is that the older car will be less dependable and he might be hit with a surprise expense from his mechanic for $2,000 at any point in time. His total expenses over time will typically be much lower, but the lower cost comes with less certainty.

Now, let’s compare this to homebuyers. As I pointed out in earlier posts, price/rent ratios tend to decline as the rental value of a home declines. Looking at low-tier and entry markets in places where affordability is an important issue, it is very common to see homes where the monthly rent is twice or more what a highly leveraged monthly mortgage payment would be for the same house.

In this context, then, one can imagine a buyer with access to credit who buys a house with a mortgage that requires a $300 monthly payment, but being a homeowner means that at any point in time the buyer may be faced with an emergency expense of several thousand dollars.

At the same time, a tenant without access to credit might rent the same house for $700 per month, but since he is not the owner, he doesn’t have the worry of unpredictable expenses.

Notice, the roles are switched compared to the scenario with car ownership. Lacking access to credit or a high income means that tenancy comes with a higher, but predictable, cost and that transportation comes at a lower, but less predictable, cost.

The way we frame both scenarios, however, is that it is risky for someone with a low income to take on debt, so it is prudent to deny them access to a mortgage or to a car payment that is high. So, even though the two scenarios have roughly opposite consequences for the consumers in question, in our mental model of what is prudent, those two contradictory scenarios both make sense.

The idea that paying $700 in rent is preferable to a $300 mortgage payment comes from the idea that a potential home buyer would be adding a new liability to their household balance sheet. It would involve leverage, and leverage is dangerous.

But this idea is, itself, a product of mental framing. There are assets and liabilities that we explicitly include on balance sheets, like the value of a home and a mortgage, or the market value of a corporation’s future profits. And there are assets and liabilities that we don’t explicitly include, like future rental expenses or the market value of a laborer’s future wages.

Some of these assets and liabilities are arbitrarily moved on and off of explicit balance sheets, depending on the context. For instance, we don’t consider future rental costs to be an explicit liability for an individual household. Yet, if that household has a pension, the pension manager most certainly accounts for that household’s future cost of living, including rent, as a liability.

If the tenant of our hypothetical house did buy it, using a mortgage, their actual household balance sheet wouldn’t become more leveraged. It’s not like their future rental costs were optional before. In practical terms, it would be nearly as disruptive for them and for the landlord if they found themselves unable to pay the rent as it will be for them and their lender if they are unable to pay the mortgage.

In a way, they are simply exchanging one liability for another. They are replacing future rent payments with future mortgage payments. In the context of marginal homeownership, leverage and price have dominated public policy debates. Those factors should be minimized instead.

Certainly, if our hypothetical household used access to a mortgage to trade up from the house with $700 rental value to a house with $1,400 rental value, then the issue of affordability becomes an important factor in the funding of that decision. But the trigger for that concern is rent—the true measure of housing consumption and affordability. The fact that that decision might be paired with a mortgage origination is not fundamentally important to the question of whether it is a prudent choice.

The idea that unsustainable household leverage was an important factor in the housing boom and the financial crisis is, at least in part, a product of selective observation. Rental income as a portion of domestic income was declining during the housing boom as the construction of more homes helped to bring down rents. Mortgages outstanding were rising, but the hidden liabilities on American balance sheets were shrinking.

Institutions like Habitat for Humanity have been successfully helping capable households with lower incomes become homeowners for years. The mission of those institutions has been hampered by a wrong-headed attempt to regulate ownership based on a concern about leverage and price. This has only caused household de facto balance sheets to become more bloated with implicit liabilities.

From the first quarter of 2009 to the first quarter of 2019, mortgage debt declined from 75 percent of gross domestic income to 49 percent.  As I noted in part 4, this may look like a victory over the “financialization” of housing, but really it mostly reflects a shift of income between equity owners and lenders.  The categories of ownership among financial firms, households, and other types of owners is relatively arbitrary.  They are all in the business of using capital to fund shelter.

The explicit financial engineering that spread before the financial crisis has taken on a lot of criticism over the past decade.  That financial engineering, ironically, created risks and costs that were more transparent and visible than the implicit financial engineering that has been an unwitting side effect of deleveraging Americans’ explicit balance sheets.

A significant part of corporate financial analysts’ academic training is to properly account for the liability of the rents corporations have committed to paying.  Wouldn’t it be prudent for mortgage regulators to account for this liability also when evaluating the benefits and costs of the lending standards applied to households?