Federal Financial Policies Collide and Consumers Lose

By Norbert Michel, Heritage Foundation Financial Regulations Expert

For decades, the federal government has become increasingly involved in education and home mortgages—a phenomenon driven by essentially the same “social” goal: Make things more affordable for more people.

But the more involved the federal government gets, the less affordable education and housing become.  And price is only part of the problem.  This article provides a great example of how badly government meddling has screwed up these markets.

The first part of the story deals with federal student loan policy.

In 2007 Congress implemented two debt-relief measures.  Both of these measures are destined to raise the cost of higher education, but I digress.

One of the measures is called income-based repayment (IBR), and it allows borrowers to cap their monthly payments at a percentage of their income.  The amount was lowered from 15 percent to 10 percent during the Obama administration, but just in case that was still too burdensome, the government decided to forgive any remaining debt after 20 years of payments.

The second policy is the Public Service Loan Forgiveness (PSLF) program.

This program allows borrowers to use IBR to cap their monthly payments and it gives them a chance to have their remaining debt wiped away after just ten years of payments.  The only catch is that the borrower has to work in a non-profit or government job.

The U.S. has an incredibly rich of history of government involvement in housing finance, and most of the results have been quite poor.  Aside from the affordability issue, federal interventions have ended in spectacular disaster several times.

Regardless, government policies have now crowded out most of the private market. Virtually all home loans made during the last few years are federally backed through Fannie Mae, Freddie Mac, or the Federal Housing Administration (FHA).

Given that federal taxpayers are backing the mortgages, it makes sense to place rules on these loans to protect taxpayers from financial risks.  Of course, being too careful with who gets a loan directly conflicts with the broad social goal of getting more people to take on home mortgages.

The system is now so convoluted that some of the mortgage rules conflict with other (non-housing) social goals.  I wouldn’t be surprised to find other conflicts, but the present tale concerns the tension between the aforementioned student lending policies and mortgage rules.

Specifically, the FHA and Fannie Mae’s underwriting guidelines make it very difficult for young professionals with student loans to buy a home.  Here’s the key passage from the FHA’s April 13, 2016 guidance on student loan payment underwriting (skip ahead if you prefer to avoid legalese and get to the punch line):

(4) Calculation of Monthly Obligation

Regardless of the payment status, the Mortgagee must use either: “the greater of: 1 percent of the outstanding balance on the loan; or the monthly payment reported on the Borrower’s credit report; or the actual documented payment, provided the payment will fully amortize the loan over its term.”

There are at least three problems here.

First, the IBR student loan rules are explicitly designed to adjust borrowers’ monthly payments downward.  Second, 1 percent of the outstanding balance on any but the smallest of student loans will easily be the greatest of the three options in the FHA rule.  Third, the actual student loan payment for anyone using the IBR option will never – by design – fully amortize the loan.

All of this means that the FHA rule can easily force the lender to base the borrower’s eligibility off an otherwise irrelevant figure: 1 percent of the outstanding balance.  This default rule causes a very big problem because it makes it very unlikely that the potential borrower’s debt-to-income ratio will meet the underwriting guidelines.

In other words, the FHA rule can automatically disqualify many borrowers because it arbitrarily adds a large lump sum to the borrower’s debt-income equation.

I’d wager that even a sizeable chunk of established professionals – much less newly minted doctors and lawyers – don’t make enough money to withstand arbitrarily adding 1 percent of their student loan balance to their debt-to-income ratio.

To be sure, Fannie and Freddie have similar rules, updated in October 2016, which rely on the 1 percent metric.

The end result is that someone with a great job that otherwise poses little financial risk to taxpayers will have an incredibly difficult time getting a home loan.  It wouldn’t even matter if the borrower’s new monthly mortgage payment would be lower than his current monthly rent payment.  Rules are rules.

The federal government has tried to advance all sorts of policy goals through the housing finance sector for nearly one century.  Overall, these policies have resulted in higher debt for millions of people, billions of dollars in taxpayer bailouts, and a less-resilient housing system than would otherwise exist.

Federal meddling has now gotten so out of control that many government rules are in direct conflict.  Aside from these conflicts, it is long past time to start getting the federal government out of the business of financing.

We have decades of experience with the federal government micromanaging debt markets to achieve social and economic goals.  It is abundantly clear that these government interventions make housing less affordable for the typical American and destabilize housing and financial markets.

Housing finance reform will be successful only if policymakers recognize the flaws of previous interventionist policies and embrace the basic principles inherent in a free market.

*Originally published in Forbes, click here.

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