Feb092015

4% mortgage rates transfer wealth from Millennials to Boomers

Today’s 4% mortgage rates represent an artificial transfer of wealth from Generation X, Generation Y, and Millennials to Baby Boomers.

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Even before the housing bubble created a great deal of false wealth, baby boomers were the recipients of an artificial boost in home prices due to 25 years of falling mortgage interest rates. At least 40% of the value of their homes was created totally by increased borrowing power of subsequent buyers.

Consider the following: the chart below shows the monthly cost of ownership from 1988 to 2015, and from 1989-1991 and again from 2011-2013, the monthly cost of ownership was approximately $1,850. Twenty-four years apart, the cost of ownership on a monthly basis was unchanged, yet house prices were nearly double. Why is that? Because in 1989, mortgage interest rates were north of 10%, and in 2012, they were 3.5%. Every penny of appreciation from 1989 to 2012 was a direct result of declining interest rates.

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So what would have happened if interest rates hadn’t changed?

Let’s go back to the stable period from 1993 to 1999. The average monthly interest rate during that period was 7.63%. The average monthly cost of ownership was $1,538. That combination would finance a loan of $223,011. Add a 20% down payment, and the home price would be about $275,000 ($278,763 to be exact). Over the last 12 months, the median monthly cost of ownership in OC was $2,102. If you plug in that number in place of the $1,538 from 1993-1999, the resulting home price would be $380,089. The last reported median home price for OC was just over $560,000. House prices have been boosted about 40% due purely to the decline of interest rates from the mid 90s to today.[dfads params=’groups=4&limit=1&orderby=random’]

So who is the beneficiary of this artificial 40% boost in home prices? Baby Boomers.

Who is the loser who pays the price for the benefit enjoyed by Baby Boomers? Everyone who wants to buy a house over the next 20-30 years.

Today’s 4% mortgage rates represent an artificial transfer of wealth from Generation X, Generation Y, and Millennials to Baby Boomers. Since these mortgage rates represent the bottom of the interest rate cycle, it’s also the end of the road for the artificial appreciation based on falling mortgage rates. Future generations won’t be so blessed — and they know it.

Unfortunately for the Baby Boomers, the next generation isn’t excited about overpaying for real estate, so sales volumes are off, particularly among first-time homebuyers. Today’s buyers don’t make the direct connection between their home purchase and funding baby boomer’s retirements even though the connection is very real; today’s buyer’s simply don’t want to pay so much for houses with little future appreciation potential, particularly when they know house prices can also go the other way.

Further, since Baby Boomers were the first generation to fully embrace the dual-income household, one of the many reasons Millennials have not become a major force in the housing market is because they are delaying marriage, and many fear they may never embrace home ownership.

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Though the transfer of wealth between generations is the primary plan to provide Baby Boomers with a comfortable retirement, so far the subsequent generations aren’t playing along.

Retiree housing wealth: Battered but still significant

Published: Feb 4, 2015, By Alicia H. Munnell

Given my enthusiasm for tapping home equity in retirement, either through buying a cheaper house or taking out a reverse mortgage, I thought it might be wise to take a renewed look at housing equity among those of retirement age. …

Reverse mortgages cause financial cancer and emotional pain; why anyone would be enthusiastic about that is difficult to understand. In my opinion, home ownership with no mortgage is the best retirement plan.

In 2013, 77% of households in their early 60s owned a house. The median house price was $185,000. But 63% of households in their early 60s continued to have a mortgage. Subtracting outstanding mortgage balances from the gross house price yields median home equity of $110,000, which accounts for more than 40% of the homeowners’ total wealth as conventionally measured. The fraction is lower if Social Security wealth and that from defined benefit plans are included in the wealth measure.Of course, the amount of home equity varies by income level. As shown in the table, the median amount of net home equity rises from $60,000 in the lowest income group to $302,000 in the highest. In contrast, the importance of home equity relative to total wealth declines as income increases.

Will the next generation buy their homes?

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The importance of home equity over most of the income distribution shows that it could provide an important source of income in retirement. This income can be accessed by moving to a smaller house, which both substantially reduces property taxes and other expenses and provides a pile of assets that can generate returns.

The alternative for those who want to remain in their home is to take out a reverse mortgage. A reverse mortgage is a mortgage: a loan with the borrower’s home as collateral. But unlike a conventional mortgage, it is designed as a way for homeowners age 62 and over, with substantial home equity, to tap that equity as a source of funds to pay bills or health care expenses or to provide additional retirement income. (Full disclosure: I am an investor in Longbridge Financial, a company that provides reverse mortgages in a socially responsible fashion.)

Reverse mortgages in a socially responsible fashion? How does one inflict a financial cancer on someone in a socially responsible fashion?

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Unlike with conventional mortgages, borrowers are not required to make monthly payments. The loan must be repaid only when the borrower moves or dies. This is the key advantage for retirees who need more income: So long as they live in their house, a reverse mortgage does not add a claim on the income they already have.

People with mortgages are eligible for a reverse mortgage, but must use those funds first to pay off their mortgage. Eliminating mortgage payments substantially reduces the demands on their monthly income.

Eliminating the mortgage payment is the best thing anyone can do for their retirement, and if this can’t be accomplished by paying off their current home, they should sell their current home and downsize into what they could own free-and-clear.

But the increase in households 60-65 with a mortgage on their home – from 53% in 1989 to 64% today – is a concerning trend.

Unlike the generations that preceded them, Baby Boomers were strongly encouraged to take out as much debt as humanly possible and be unconcerned about paying it back. It is troubling, but not surprising, they have far more debt than they should heading into retirement.

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Paying the Baby Boomers Twice

Who will fund the retirements of Baby Boomers? Since housing was touted as the best retirement savings vehicle, and since 25 years of falling interest rates inflated the resale values of these properties, Baby Boomers fully expect to sell their homes for a large sum to provide for their retirements. The housing bust frighted many seniors as their property values crumbled, but the successful market manipulations since have reflated the bubble and given many seniors hope.

Perhaps some seniors will foolishly take out reverse mortgages to fund their retirement despite the fact that reverse mortgages are a really, really bad idea; however, most hope to sell their homes and enjoy a generational transfer of wealth from those working today to those who want to retire. Workers will already pay a great deal to Baby Boomers through Social Security, but in addition to this burden, workers must pay inflated house prices to buy a Baby Boomer out of their overpriced homes — assuming today’s workers don’t rebel and chose to rent instead.


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