Tuesday, March 22, 2005

Homeowners in Hock

Robert Lenzer

People use their homes to finance spending sprees. How long can this go on?
What's this? Allan Greenspan favoring a consumption tax? Which he did, in his usual circumspect fashion when discussing fiscal policy, in a congressional hearing Mar. 3.

There must be something bothering the Fed chairman. That something seems to be the dismally low savings rate in this country. A tax that zeroed in on money spent rather than money earned just might cure the problem, by inspiring people to earn money and then save it.

As it is, the personal savings rate has fallen from 6% of GDP 12 years ago to a mere 1% now. Low savings could leave a lot of the middle class ill-equipped to handle retirement. With or without reform Social Security doesn't seem adequate to the task.

There are a lot of reasons for a low savings rate, but an important one is the ease with which people can unsave, using their home equity. You buy a house for $250,000, putting down $50,000. A decade later you move, selling this house for $500,000 and buying a new one for $500,000. But instead of putting your $300,000-plus of equity from the old house into the new one, you once again put down only 20%, or $100,000. That leaves $200,000 of cash left over. You can spend it on cars and vacations.

There's another way to extract cash from your mortgage. Without moving, take out a home equity line or second mortgage. So long as this new borrowing is $100,000 or less, the interest on it is deductible (unless you are subject to the alternative minimum tax).

Unsaving
Low mortgage rates have made it easy for homeowners to leverage their property to extract cash. Fed Chairman Alan Greenspan is concerned.
Sources: U.S. Census Bureau; Economy.com.
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"Low mortgage interest rates have encouraged significant growth of home equity loan advances and cash-out refinancings, which are another channel for the extraction of previously unrealized capital gains on homes," Greenspan said in a speech in London in February. He went on to say that the extraction of home equity is helping finance consumer expenditures, including imports that "presumably" contribute to the trade deficit (which was $618 billion last year).

Greenspan is not an alarmist. He doesn't foresee a home price collapse and a wave of bankruptcies. He's just concerned that people are using the rise in home values to finance personal spending. It's not quite the same as spending money you earned from a paycheck.

According to figures compiled by the Federal Reserve, household net worth has risen from $28 trillion in 1995 to $47 trillion at the end of the third quarter 2004. Residences are collectively worth $16.6 trillion, and mortgages against them total $7.3 trillion. Greenspan, in another public appearance, alluded to this "fairly large buffer against price declines."

How much home equity extraction is going on? We plot some estimates in the chart. Take the estimated $861 billion rise in mortgage debt outstanding in 2004. Now subtract the amount of that incremental mortgage lending associated with new home construction. The value of new homes built was $324 billion; if they were acquired with, on average, 90% mortgages, then $292 billion of the rise in mortgage debt has an innocent explanation--it added to the stock of real capital assets. That leaves $569 billion worth of homeowners who refinance, take out second mortgages or simply extract cash when they move--and then spend some or all of that loot to support their lifestyles.

If your thrift consists of putting no money in the bank but just watching your suburban home escalate in value, you may be in for disillusionment. At age 68 you'll be living in a lovely $2 million house. But how are you going to pay the light bill?

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