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Housing report fires warning on creative financing

June 14, 2005

Interest-only and adjustable loans add risk to markets


Inman News

Although record home-ownership levels and booming home construction give the impression of a perfect housing market, the increase in interest-only and adjustable-rate loans could put an end to the jubilance, according to the State of the Nation's Housing report from Harvard University's Joint Center for Housing Studies.

Subprime loans have given millions with blemished credit records, who would previously have been denied a loan, the chance to buy a home, and interest-only and adjustable-rate loans are helping blunt the impact of higher home prices. Adjustable-rate mortgages accounted for more than a third of all mortgage loans last year and interest-only loans for nearly one-quarter, the report found.

"The irony of today's housing market is that while fundamentals are supporting record levels in residential investments, housing affordability problems are climbing the income scale," said Nicolas P. Retsinas, director of Harvard's Joint Center for Housing Studies.

This year's report cautions that creative financing is adding to risk. Although interest-only and adjustable loans can initially save a typical home buyer hundreds of dollars in monthly payments, these loans also leave borrowers vulnerable to sharply higher payments when interest rates adjust or principal payments start to become due.

"With the number of borrowers vulnerable to payment shocks up, default rates predictably several times higher for subprime than prime loans, and house prices growing at such rapid rates, the housing market could deteriorate if the economy softens or if rates increase sharply," Retsinas said.

Payment shocks for most owners are still several years out. Many will sell their homes or refinance before they face these shocks. However, short-term risks of price declines and rising defaults will likely remain low if the economy continues to expand. When the economy hits a soft spot, though, housing corrections may be more painful than they would otherwise have been, according to the report.

Looking ahead, the report finds reason to believe that residential investment will reach new heights again over the next 10 years. Strong levels of immigration are bolstering household growth and productivity gains are driving increases in real incomes. The baby boom generation is reaching their mid 40s to early 60s with record income and wealth. This will lift the demand especially for second homes, homes marketed to seniors, and large remodeling projects. Meanwhile, the entrance of the children of the baby boomers into young adulthood will lift rental and starter-home demand.

"While the future looks bright for housing investment, there is little cause for optimism that the nation's housing affordability challenges will diminish; in fact they are growing worse," notes the Center's Executive Director Eric Belsky. Between 2000 and 2003 alone, the numbers of households spending more than half of their income on housing increased by 2.5 million. "Housing affordability is a chronic problem and narrowing the gap between what decent housing costs and what low-wage workers and retirees can afford will remain a major national challenge."

Indeed, households are increasingly taking longer, more costly commutes to lower housing costs. Nationally the number of workers taking commutes of an hour or more surged by 3.1 million in the 1990s. Up and down the income scale, spending less on housing typically means spending more time and money on the road.

Harvard's Joint Center for Housing Studies is a center for information and research on housing in the United States.

Copyright 2005 Inman News



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