Mortgage equity withdrawal should be regulated like loans from retirement accounts

Politicians favor home ownership because it serves as a proxy for retirement savings; however, unrestricted mortgage equity withdrawal defeats the purpose.

double-indemnity-HELOCPoliticians provide many reasons for supporting home ownership through policy initiatives and outright subsidies, but one of the primary reasons they support home ownership is the forced savings account properties of an amortizing mortgage. History has shown that homeowners have more comfortable retirements than renters, and an abundance of home equity is one of the main reasons.

Unfortunately, politicians allow homeowners to raid this retirement piggy bank with unrestricted mortgage equity withdrawal — an allowance politicians don’t provide to retirement savings accounts. People are still allowed to borrow against their retirement savings for specific things, like a mortgage down payment, but the system is heavily regulated to make sure people don’t empty their retirement savings accounts for current consumption. The same protections should be extended to mortgage equity withdrawal if politicians are serious about maintaining this important reservoir of retirement savings.

Unrestricted mortgage equity withdrawal promotes housing bubbles

Lenders enabled the housing bubble, but people needed a reason to provide the demand to pay stupid prices to inflate a housing bubble. The motivation to make a foolish purchase comes from the desire to capture property appreciation and convert it to immediate spending through mortgage equity withdrawal.flapper

In order for home price appreciation to motivate people to pay stupid prices and inflate housing bubbles, they need a way to access this appreciation. The more immediate and plentiful this access to money, the more motivated buyers are to borrow and cash out. Mortgage equity withdrawal is the doorway to appreciation; it makes houses very desirable and very valuable.

Further, mortgage equity withdrawal provides a consumptive tax benefit unavailable to renters. Nobody is allowed to deduct credit card or auto loan interest, but if those consumptive purchases are rolled into a home loan through mortgage equity withdrawal, then the borrower can deduct the interest, making this consumptive debt subsidy available only to homeowners. This tax subsidy promotes financing short-term consumption with long-term debt, an extremely foolish idea, but one eagerly embraced by debt-addicted homeowners running personal Ponzi schemes.

Consumptive borrowing is detrimental to economic growth in the long term because debt-service payments diverted to lender profits is money taken out of the local economy where it would otherwise by purchasing goods and services. So not just does unrestricted access to mortgage equity inflate housing bubbles, it also exacerbates the ups and downs of the economic cycle.

Many economic theories are difficult to prove as evidence is always clouded by a multitude of related variables that don’t simplify down as neatly as many macroeconomic models suggest they do. However, this particular theory about mortgage equity withdrawal promoting bubbles and exacerbating the economic cycle has extremely compelling evidence that’s difficult to deny.

Texas shows the way

few_dollars_moreTo test this premise, we need to find a market with limited access to mortgage equity withdrawal and compare the home prices and economic output there to a market like California’s where there are no restrictions at all. There is such a place: Texas.

I know Texas. I spent two and one-half years living in College Station studying real estate. Texas, along with California, was a big player in the Savings and Loan disaster. They inflated a commercial real estate bubble of epic standards, and even its residential real estate was volatile during that period. Texans are certainly not immune to the temptation to take free money from lenders. However, the delivery mechanism of the Savings and Loan disaster was through commercial lending whereas the delivery mechanism during the Great Housing Bubble was residential lending. Texas has different laws governing residential lending, and these laws prevented a housing bubble there.

In Texas the total loan-to-value ratio on any cash-out or HELOC can’t exceed 80% by state law; it’s actually written into the State constitution. People can borrow more to purchase a property, but then they must wait until they have more than 20% equity before they can even consider mortgage equity withdrawal. This effectively puts a lockbox on home equity.

Without access to mortgage equity, Texans had little incentive to bid up house prices; plus, since their property taxes are about double what we pay here in Calfornia, and since these taxes rise with value without a cap, Texans had a large disincentive to run up home prices. As a result, they didn’t inflate a housing bubble in Texas when the rest of the country did.hell_to_pay

So how did Texas fair economically? Texas largely avoided any negative consequences from the 2008 financial meltdown. House prices didn’t fall much, few borrowers fell into foreclosure, and the Texas State economy has consistently been among the strongest in the nation over the last seven years. More people move to Texas from California than any other state. What does that tell you about the California economy relative to Texas’s economy?

If a house is supposed to represent financial security, it should be a place of money storage, not an endless ATM machine spitting out spending money. The Texas experience shows that if you deny people access to this money, the housing market is more stable, and everyone has tangible ownership in their property with real equity. That is the real American dream.