Homeownership: Information on Mortgage Options and Effects on Accelerating Home Equity Building

The federal government has a number of programs to help increase access to affordable homeownership for first-time buyers and lower-income households, including programs that provide guarantees for certain types of mortgages and funding that can be used for down-payment assistance. Generally, homeowners can build home equity by making payments on a mortgage to reduce the outstanding principal (assuming home value does not depreciate). Recently, there has been interest in mortgage products that accelerate home equity building.

GAO was asked to explore options for building equity through homeownership. This report discusses (1) how federal homeownership assistance programs affect home equity building; and (2) options, including private-sector mortgage products, through which borrowers can accelerate home equity building and the trade-offs of these options for both borrowers and lenders.

GAO analyzed relevant laws and program guidance of federal homeownership assistance programs. GAO attended housing conferences and interviewed relevant federal and state agency officials, academics, and industry stakeholders, including mortgage insurers and lenders, to identify existing and proposed accelerated equity-building products and mechanisms and to better understand the benefits and trade-offs of accelerated equity building. GAO also developed examples of mortgage scenarios to illustrate the trade-offs of accelerated equity building. Federal agencies provided technical comments, which were incorporated where appropriate.

Federal homeownership assistance programs generally are not designed to accelerate equity building (home equity is the difference between the value of a home and the amount owed on a mortgage). For example, programs that offer grants for down-payment assistance can provide a one-time boost to home equity. However, these programs are not specifically designed to accelerate equity building—that is, increasing the pace of paying off principal more quickly than would be the case with a 30-year fixed-rate mortgage. Instead, the focus of federal programs is on providing affordable access to homeownership, including through grants, loans, and mortgage insurance or guarantees. For instance, federal mortgage insurance programs help provide market liquidity by protecting lenders from losses, in turn increasing access to credit and homeownership, and ultimately, the opportunity for equity building for home buyers.

Borrowers have options to accelerate equity building that include obtaining shorter-term mortgages, making more frequent or additional payments, or choosing a mortgage product designed to accelerate equity building. For example, a mortgage product introduced by private lenders in 2014—the Wealth Building Home Loan (WBHL)—has features designed to accelerate equity building, including shorter terms (15 or 20 years) and the option to buy down the interest rate. The product also allows for no down payment. However, these products have trade-offs, including the following:

Shorter-term loans build home equity (in terms of principal reduction) at a faster rate, but require higher monthly payments (see fig.). Payments for a 15-year fixed-rate mortgage can be more than 40 percent higher than for a 30-year fixed-rate mortgage.

Higher payments may make mortgages less affordable or limit access for lower-income borrowers. For example, higher payments may result in a higher debt-to-income ratio for some home buyers, which may prevent them from qualifying for a mortgage unless they buy a less expensive home.

In contrast, all else equal, loans with a shorter term generally have reduced credit risk—the likelihood of a home buyer defaulting on a mortgage—for lenders.

Note: Monthly mortgage payments do not include property tax or any type of insurance. Interest rates used are generally consistent with market rates in September and October 2017.

The federal government has a number of programs to help increase  access to affordable homeownership for first-time buyers and lower- income households, including programs that provide guarantees for  certain types of mortgages and funding that can be used for down- payment assistance. Homeownership has long been perceived to  provide a number of financial and nonfinancial benefits. For example,  homeownership can build wealth through the accumulation and  appreciation of home equity—the difference between the value of a home  and the amount owed on the mortgage. Home equity can serve as a  financial cushion in times of hardship or financial emergencies, especially  among lower-income households for whom housing generally constitutes  a larger percentage of assets than for higher-income households.

According to the U.S. Census Bureau, the homeownership rate was  about 64 percent at the end of the third quarter 2017, and according to  the Board of Governors of the Federal Reserve (Federal Reserve), the  total outstanding mortgage debt in the same period was $10.5 trillion. In  addition, more than 21 percent of homeowners had less than 20 percent  equity in their homes (see app. II for more information). According to our  analysis, for a borrower who bought a home with a 30-year fixed-rate  mortgage and a small down payment, it could take more than 8 years in  the current interest rate environment to achieve 20 percent equity in the  home (assuming the home’s value remained unchanged from loan  origination). Homeownership can build wealth, but it also entails risks  (such as depreciating home values) and costs (such as for maintenance,  taxes, and insurance). Recently there has been some interest in  mortgage products designed to accelerate equity building—that is,  products that increase the ongoing pace of paying off the loan principal  compared to a traditional 30-year fixed-rate mortgage—and improve  access to homeownership.

You asked us to explore options for building equity through  homeownership. This report describes (1) how federal homeownership  assistance programs affect home equity building, and (2) options,  including private-sector mortgage products, through which borrowers can  accelerate home equity building and the trade-offs of these options for  both borrowers and lenders. You also asked us to include regional data  on equity building, which is included in an appendix to this report.

To address these objectives, we reviewed relevant literature, including  prior GAO reports on housing assistance and homeownership, housing  finance, and mortgage reforms. We interviewed officials with knowledge  of federal homeownership assistance programs from the Department of  Housing and Urban Development (HUD), Federal Housing Finance  Agency (FHFA), Department of Agriculture (USDA), Department of  Veterans Affairs (VA), Fannie Mae, Freddie Mac, Federal Home Loan  Banks (FHLBanks), and state housing finance agencies. We attended  housing conferences and met with housing experts and stakeholders from  academia, housing advocacy organizations, and industry, including  mortgage lenders and insurers, selected because they made proposals to  increase homeownership or build home equity faster, wrote on  homeownership issues, were recommended by government officials, or  were involved in providing mortgage products designed to accelerate  equity building. From interviews with industry stakeholders and housing  conferences we attended, we were able to identify and review information  on two private-sector mortgage products—one existing and one  proposed—designed to accelerate home equity building. We used  examples from those products to illustrate effects and trade-offs on home  equity of select scenarios. See appendix I for more information on our  scope and methodology.

We conducted this performance audit from January 2017 to March 2018  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.

A homeowner can build home equity immediately by making a down  payment on their home, assuming the down payment is not financed  separately as a loan. Throughout the life of a mortgage, homeowners  can continue to build equity (1) by making regular mortgage payments to  reduce the principal amount outstanding, (2) by making additional  payments to further reduce the principal amount outstanding, and (3)  through appreciation in their home’s value. Additionally, the components  of a mortgage (discussed below) may affect the pace of home equity  building.

Throughout this report, for the purposes of illustrating home equity  building, we assumed that a home’s value remained unchanged from the  time of the loan origination. However, home values are highly contingent  on market conditions and other factors that are beyond a homeowner’s  control. For example, although homes can appreciate in value, homes  also can depreciate in value, which can have a negative effect on  homeowners’ equity. Homeowners also could lose money on their home if  they sold it shortly after purchasing because principal reduction in the  initial years of a mortgage is relatively small and the benefit of any home  value appreciation would be limited. Additionally, selling a home incurs  transaction costs, such as realtor commissions. To avoid losing money on  a home sale, homeowners would need to sell their home at an amount  higher than their purchase price plus transactions costs. For example, if a  homeowner buys a home for $250,000 (all fees included) and plans to  sell it 3 years later, assuming transaction costs of 10 percent (or  $25,000), the homeowner would have to sell the home for at least  $275,000 to break even, meaning an annual appreciation in home value  of more than 3 percent. If the home’s value did not appreciate at that rate,  or depreciated, the homeowner would lose money on the sale.

The majority of American families achieve homeownership by taking out a  loan—a mortgage—to cover at least some of the purchase price. The  primary components of a mortgage loan are the following:

Term (duration). The most common term is 30 years. According to  the Urban Institute, the 30-year fixed-rate mortgage represented  approximately 90 percent of the fixed-rate purchase mortgages (that  is, not for refinancing an existing mortgage) originated every month  from January 2010 through July 2017, and 15-year fixed-rate  purchase mortgages represented about 6 percent.

Down payment. Most mortgage lenders require borrowers to make a  down payment (of 3 percent or more of the purchase price, depending  on the mortgage) that is applied to the purchase price of the home. A  down payment also helps a borrower build home equity, assuming the  down payment is not financed as a separate loan.

Interest rate. Lenders charge borrowers a percentage of the  mortgage amount, in exchange for providing funds to buy a home. An  interest rate can be fixed or adjustable for the life of the mortgage  (adjustable-rate mortgage or ARM). Because a fixed-rate mortgage’s  interest rate does not change regardless of prevailing rates, a  borrower’s payments for principal and interest remain the same for the  life of the mortgage. In contrast, an adjustable-rate mortgage’s  interest rate, for which the initial interest is generally lower than for a  fixed-rate mortgage, will adjust at agreed-upon intervals. As a result,  adjustable-rate mortgage payments can increase or decrease  depending on the changes in interest rates and terms of the loan.

Payment frequency and amount. Payments are generally made on  a monthly basis. Fixed- and adjustable-rate mortgages generally have  fully amortizing payment schedules—that is, the regularly scheduled  payments will fully pay down the principal and interest over the life of  the mortgage, with the amounts allocated to reducing principal and  interest changing over time (see fig. 1).

The U.S. markets for single-family housing finance include a primary  market, in which lenders make (originate) or refinance mortgage loans,  and a secondary market, in which mortgage loans are purchased from  lenders and packaged into securities—known as mortgage-backed  securities—that are sold to investors. The federal government  participates in the primary and secondary mortgage markets.

In the primary market, federal agencies provide homeownership  assistance programs and products intended for increasing access to and  affordability of homeownership. Relevant federal agencies and a  government-sponsored enterprise that provide homeownership  assistance and their primary housing-related policy goals include the  following:

Department of Housing and Urban Development provides housing  assistance to low-and moderate-income families and promotes urban  development.

Federal Housing Administration (FHA) seeks to broaden  homeownership, strengthen the mortgage marketplace, and  increase access to credit by providing mortgage insurance.

Public and Indian Housing helps ensure safe, decent, and  affordable housing through programs such as housing choice  vouchers.

Community Planning and Development seeks to develop viable  communities and provide decent housing and a suitable living  environment through block grant assistance.

Department of Veterans Affairs assists service members, veterans,  and eligible surviving spouses of veterans to become homeowners  through guaranteeing and issuing (in limited circumstances)  mortgages for home purchases.

Rural Housing Service (RHS), which is an agency within USDA,  insures and guarantees housing loans for home purchases, repair,  and rental housing development.

Federal Home Loan Banks help provide liquidity to each bank’s  member financial institutions to support housing finance and  community investment. FHLBank members include commercial  banks, thrifts, and credit unions. FHLBanks provide 10 percent of their  earnings for affordable housing programs, including grants for  affordable housing for households with incomes at or below 80  percent of the area median.

Federal homeownership assistance programs can be categorized in  terms of the products or services they offer or the mechanisms they use.  The categories include mortgage guarantees and insurance, down- payment assistance, vouchers, and direct loans (discussed in more detail  later in this report). In addition to these categories of homeownership  assistance, tax expenditures, such as exclusions, exemptions, deductions  (including the mortgage interest deduction), credits, deferrals, and  preferential rates, can promote homeownership. For example,  homeowners can take advantage of tax deductions (by choosing to  itemize deductions on their tax returns) to help lower their taxable income.  Taxpayers who itemize deductions may deduct qualified interest they pay  on their mortgage. Taxable income may be reduced by the amount of  interest paid on first and second mortgages of up to $750,000 for homes  purchased generally after December 15, 2017. Additionally, taxpayers  generally may deduct up to $10,000 for state and local taxes, including  property taxes paid by homeowners on their homes.

Participation in the secondary mortgage market occurs through the  following entities:

Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac are  government-sponsored enterprises (enterprises)—congressionally  chartered, for-profit, shareholder-owned companies. They are the two  largest participants operating in the secondary mortgage market.  Generally, Fannie Mae and Freddie Mac purchase mortgage loans  that meet certain criteria for size, features, and underwriting  standards—known as conforming loans—from lenders. In  purchasing loans, the enterprises provide market liquidity, so lenders  can provide more loans to borrowers.

Ginnie Mae. Ginnie Mae is a wholly-owned government corporation.

Ginnie Mae guarantees the timely payment of principal and interest on  mortgage-backed securities supported by pools of loans backed by  government-insured mortgages, including mortgages insured by FHA,  VA, and USDA.

In a process called underwriting, mortgage lenders evaluate the  creditworthiness of potential borrowers in making mortgage loans, among  other things. Amid concerns that risky mortgage products and poor  underwriting standards contributed to the recent housing crisis, Congress  included mortgage reform provisions in the Dodd-Frank Wall Street  Reform and Consumer Protection Act (Dodd-Frank Act). The Dodd-Frank  Act generally requires lenders to determine consumers’ ability to repay  home mortgage loans before extending credit and provides a  presumption of compliance with the ability-to-repay requirement for  qualified mortgages.

The ability-to-repay regulations set forth lenders’ responsibilities to  determine a borrower’s ability to repay a residential mortgage loan, and  special payment calculation rules apply for loans with balloon payments,  interest only payments, or negative amortization. The regulations  require lenders to make a reasonable and good faith determination of a  consumer’s reasonable ability to repay a loan. The regulations establish a  safe harbor and a presumption of compliance with the ability-to-repay rule  for certain qualified mortgage loans (QM). The rule generally prohibits  loans with negative amortization, interest-only payments, or balloon  payments from being qualified mortgages, and limits the points and fees a  lender may charge borrowers on a qualified loan. The regulations  establish general underwriting criteria for qualified mortgages. For  example, under QM requirements borrowers generally cannot exceed a  maximum monthly debt-to-income ratio of 43 percent, unless the loan is  eligible for sale to an enterprise. If a mortgage loan meets the  requirements of a QM loan, it is eligible for the safe harbor and the lender  is deemed to have complied with the ability-to-pay requirement unless the  loan is a higher priced mortgage loan. A higher priced mortgage loan that  otherwise meets the definition of a QM is presumed to have complied with  the ability-to-pay requirements, but the presumption can be rebutted if the  consumer proves that the lender did not make a good faith and  reasonable determination of the consumer’s ability to repay.

Additionally, federal mortgage insurance is included in the determination  of whether an FHA-insured loan is a higher priced mortgage loan.

Federal Homeownership Assistance Programs Can Have Equity- Building Effects, but Are Not Specifically Designed to Accelerate Equity Building

Existing federal homeownership assistance programs use features and  mechanisms that can have equity-building effects, but the programs are  not specifically designed to accelerate equity building. The programs can  assist homeowners to build equity over time by providing access to  homeownership, but the programs do not have an explicit focus on  accelerating the ongoing pace of paying down the loan principal faster  than a 30-year fixed-rate mortgage. Rather, the overall focus of the  programs is on providing affordable access to homeownership, according  to officials of relevant agencies and entities and based on their mission  goals. For example, the goal of FHA’s mortgage insurance program is to  facilitate access to affordable mortgages for home buyers who might not  be well-served by the private market. FHA implements this goal by  providing insurance to lenders to facilitate access to mortgage financing  for lower-income home buyers.

See table 1 for examples of federal homeownership assistance programs,  by major program types and potential for affecting equity building, either  at a point in time or throughout the life of a mortgage.

Federal Mortgage Insurance and Loan Guarantees Increase Market Liquidity

Federal mortgage insurance and guarantee programs increase market  liquidity, which ultimately expands access to homeownership. The federal  government commits to pay part or all of a loan’s outstanding principal  and interest loss to a lender or other mortgage holder if the borrower  defaults. Because they obtain insurance or a guarantee against the  possibility of loss from borrower default, lenders are more willing to  provide loans to borrowers who might not otherwise be served by the  private market, allowing more homeowners—particularly lower-income  borrowers—an opportunity to build home equity.

FHA offers mortgage insurance and RHS and VA provide loan  guarantees. For example, FHA will insure loans with a down payment as  low as 3.5 percent from most borrowers, and conventional mortgages will  allow down payments as low as 3 percent. FHA-insured loans also have  more lenient credit requirements that particularly benefit minority  households and first-time home buyers who might otherwise find it difficult  or more expensive to take out a mortgage. Among federal mortgage  insurance programs, FHA has the highest volume of mortgages insured.

Federal Down-Payment Assistance Programs Can Have Equity-Building Effects

Federal and federally mandated programs that provide funding for grants  and loans for down-payment assistance can have equity-building effects.  Although accelerated equity building is not the policy goal of these  programs, down-payment assistance can lower the barrier to  homeownership for some lower-income home buyers so that the equity-building effects of homeownership can accrue. Examples of programs  include the following:

HUD’s HOME Investment Partnership Program is a block grant  program that provides funding to states and localities to be used  exclusively for affordable housing activities to benefit low-income  households. Funds can be used for down-payment assistance for  eligible low-income home buyers. According to HUD data, more than  75 percent of low-income home buyers who have received assistance  from the HOME program have used HOME funds for purchasing a  home (which includes down-payment assistance) since the program’s  inception in 1992, directly contributing to homeowner equity building.

HUD’s Community Development Block Grant (CDBG) program also  provides funding to eligible states and localities for community and  economic development efforts, including housing assistance.  Eligible uses of home-buyer assistance include grants for down  payments and closing costs. In fiscal year 2016, CDBG funds  provided direct housing assistance for down payment and closing  costs to 2,483 households.

FHLBanks contribute funding to the Affordable Housing Program  (AHP), which can provide grants for down-payment assistance  through either the AHP competitive or set-aside program. Member  financial institutions of the FHLBanks can apply for the set-aside  funds and then distribute the funds as grants to eligible households.  Set-aside grants may be no greater than $15,000 per household, and  at least one-third of the FHLBanks’ annual set-aside allocation must  be used for eligible first-time home buyers. According to FHFA, the  FHLBanks funded about $77 million for down-payment or closing-cost  assistance in 2016 (almost 90 percent of total set-aside program  funding). The down-payment assistance grants have an immediate  equity-building effect.

RHS and HUD administer self-help grant programs that provide  opportunities for very-low and low-income home buyers to purchase  subsidized homes: Program participants help construct homes in  exchange for subsidies, including down-payment assistance. RHS  officials told us that the home buyer’s labor serves as a down  payment for the home, providing the home buyer with equity at the  time of purchase. RHS’s program also includes a subsidized interest  rate determined by the home buyer’s income, as well as a 33-year  mortgage duration that can be extended up to 38 years, to reduce the  monthly mortgage payment and make the loan as affordable as  possible.

HUD officials raised concerns about the extent to which down-payment  assistance promotes home equity building. For example, some  mortgages with down-payment assistance can be associated with higher  delinquency rates. Specifically, HUD officials pointed to data indicating  that FHA has experienced higher loan delinquency rates for loans with  down-payment assistance. As with any homeownership-assistance  programs or mortgages, the potential for home equity building requires a  homeowner to sustain and pay down the mortgage.

In addition to down-payment assistance, HOME, CDBG, and AHP funds  can be used for buying down the mortgage interest rate. Interest-rate  buy-downs have accelerated equity-building effects throughout the life of  the mortgage because a higher proportion of monthly mortgage payments  are applied to the mortgage principal. However, agency and enterprise  officials and housing experts with whom we spoke said the down payment  is the biggest barrier to homeownership, and in the current environment  of low interest rates, buy-downs of interest rates are not common.

In addition to federal programs, some state housing finance agencies also  provide down-payment assistance grants and loans that have accelerated  equity-building effects. For example, the Minnesota Housing Finance  Agency provides a monthly payment loan (in addition to the mortgage) of  up to $12,000 to be used for down payments or closing costs. The  monthly payment loan has an interest rate equal to the rate on the  borrower’s first mortgage, and the loan can be paid back over a 10-year  period. According to Minnesota Housing Finance Agency officials, by  making payments directly on the monthly payment loan, the borrower is  effectively accelerating equity building on that part of the home purchase  because of the shorter term compared to a 30-year mortgage.

Federal Voucher Program Can Facilitate Equity Building

HUD’s Housing Choice Voucher Program provides assistance in helping  a homeowner pay for monthly mortgage and other homeownership  expenses, which facilitate homeownership and equity building.  Vouchers are administered locally by public housing agencies, but not all  public housing agencies participate in the program. A home buyer would  have to apply for a housing choice voucher with a participating public  housing agency to use the funding for a mortgage instead of rent. First- time homeowners who meet income limits and receive homeownership  counseling can qualify for the program. The payment assistance  generally continues as long as the family resides in the home, and the  maximum term for the assistance is 15 years if the home purchase is  financed with a mortgage longer than 20 years. According to HUD,  about 11,000 homeowners were receiving assistance from the  Homeownership Voucher Program as of September 2017, about 0.5  percent of all vouchers.

Federal Direct Loans Can Provide Access to Homeownership

RHS and VA both offer direct loans for home purchases to eligible  borrowers who may otherwise be unable to obtain financing in the private  marketplace, providing access to homeownership and equity building.  RHS offers direct loans to borrowers in rural areas with incomes of  generally not more than 80 percent of the area median income. Loan  funds can be used to build, repair, renovate, or relocate a home, or to  purchase and prepare sites, including providing water and sewage  facilities. RHS provided 7,089 direct loans for single-family homes in fiscal  year 2016.

VA provides direct home loans to eligible Native American veterans to  finance the purchase, construction, or improvement of homes on federal  trust land, or to refinance a prior direct loan to reduce the interest rate.  According to VA, 13 direct loans were provided to Native Americans in  fiscal year 2016.

Options and Mechanisms That Accelerate Equity Building Present Trade-offs for Homeowners and Lenders

Borrowers have options to accelerate equity building that include  obtaining shorter-term mortgages, making more frequent or additional  payments, or choosing a mortgage product available in the private  mortgage market designed to accelerate equity building. These options  accelerate equity building by affecting the key components of a  mortgage—term (duration), down payment, interest rate, or payment  frequency or amount. The advantages of building equity faster can  include using home equity as a financial cushion in emergencies, like  unexpected medical expenses. However, there are trade-offs to these  options, such as higher monthly payments for shorter-term mortgages.  Additionally, stakeholders identified key trade-offs and considerations in  introducing new products and mechanisms for accelerating home equity  building that could affect the success of the products or mechanisms.

Home buyers and Homeowners May Take Actions on Their Own to Accelerate Equity Building

Home buyers and homeowners may take actions on their own to  accelerate home equity building. For example, home buyers can choose  a 15- or 20-year mortgage rather than a 30-year mortgage. The shorter- term product will increase the relative pace of equity building. In July  2017, almost 6 percent of all new purchase mortgage originations were  for 15-year fixed-rate mortgages, according to the Urban Institute.  However, shorter-term loans may present trade-offs for borrowers, which  we discuss later in the report.

Homeowners also can make extra mortgage payments to further reduce  the principal balance, which can accelerate equity building and shorten  the mortgage term. For example, according to our analysis, a homeowner  making an extra monthly payment of $100 on a 30-year fixed-rate  mortgage for $225,000 would accelerate equity building and reduce the  mortgage duration by more than 4 years (see fig. 2). Homeowners  generally have the flexibility to make extra payments at their discretion  and could discontinue the extra payments at any time if they need the  funding for other priorities.

Homeowners also can refinance their mortgage to take advantage of  lower interest rates, shorter mortgage terms or both. Lower-interest and  shorter-term loans can help build equity faster. About 27 percent of  mortgage refinances were for 15-year fixed-rate mortgages in October  2017, according to enterprise data reported by FHFA. However,  refinancing (similar to purchase loans) incurs transaction costs (see table  2). A lender may offer low- or no-cost refinancing, but likely would  charge a higher interest rate in exchange for lowering or eliminating fees.  Additionally, other payments might be required at closing (which would be  out-of-pocket expenses unless they were financed), including upcoming  mortgage insurance and property taxes.

Also, homeowners who refinance to take advantage of lower interest  rates could extend their mortgage term or choose to cash out some of the  existing home equity, thereby eliminating the potential for accelerated  equity-building effects in refinancing. See figure 3 for a comparison of  how different refinancing options can affect home equity building.

A Recently Introduced Mortgage Product Accelerates Equity Building through Shorter Terms and Lower Interest Rates

The Wealth Building Home Loan (WBHL) is a relatively new private- sector mortgage product that incorporates a number of features  specifically designed to accelerate equity building (see fig. 4). The WBHL,  which has been offered commercially on a limited basis for about 3 years,  has shorter mortgage terms (15 or 20 years), can have a fixed or  adjustable rate, and allows the interest rate to be bought down. A lower  interest rate would allocate a greater portion of each monthly payment to  reduce mortgage principal and also reduce the amount of the monthly  payments.

Moreover, the WBHL allows for no down payment (including allowing the  financing of closing costs). The no down-payment feature is designed to  facilitate access to homeownership. According to lenders we spoke with  who offer WBHLs, allowing for no down payment is the key feature that  distinguishes the WBHLs from standard 15- or 20-year mortgage loans  available in the private-sector mortgage marketplace. Consistent with  what we heard from lenders, officials from Fannie Mae and Freddie Mac  told us loans that do not require a down payment generally are not  available in the private-sector mortgage marketplace. Additionally,  because of the low or no down-payment features, lenders we spoke with  who offer WBHLs typically require private mortgage insurance, which is  provided by a major mortgage insurer.

As shown in figure 4, the monthly mortgage payments of a WBHL can  increase substantially, compared with the payments of a 30-year fixed- rate mortgage.

Some lenders we interviewed offer WBHLs with the option to buy down  the interest rate, and some require a minimum buy-down.

One lender requires borrowers to pay 2 points (or 2 percent of the  mortgage loan amount), which buys down one-half of a percentage  point of the interest rate.

Another lender offers a 15-year loan with an option to pay 3 points to  buy down the interest rate to 1.75 percent for the first 7 years. Rates  increase to 5 percent for the remaining 8 years. The lender also offers  a 20-year loan with the option to pay 2 points to buy down the interest  rate to 2.99 percent for the first 7 years. Rates increase to 5.25  percent for the remaining 13 years.

Although the option to buy down the interest rate has been advanced as a  feature that accelerates equity building, some lenders we interviewed said  that borrowers tend to pay the minimum required points only, because  borrowers generally prefer to pay as little cash as possible at loan  origination. Additionally, some lenders and other stakeholders have said  that, in a low interest-rate environment, the incentive for borrowers to buy  down the mortgage interest rate is greatly reduced.

A Proposed Mortgage Product May Accelerate Equity Building through an Equity Savings Account

Another mortgage product that we identified during our review—the  Fixed-Payment Cost-of-Funds Index (Fixed-COFI) Mortgage—has been  proposed by two economists, but has not yet been offered by private- sector lenders. This type of mortgage is intended to provide another  option for consumers that encourages equity building and limits exposure  for borrowers and lenders to interest rate fluctuations. The Fixed-COFI  would allow borrowers with little or no money down to obtain an  adjustable-rate mortgage that features a fixed monthly mortgage payment  and an equity savings account. Funds in the equity savings account  could be used to pay down the mortgage principal, thereby accelerating  home equity building. According to the economists of this proposed  product, the low to no down-payment feature may help individuals with  little to no savings access homeownership, particularly those who live in  high-cost areas where the rent payment is comparable to a mortgage.

In addition to the borrower’s fixed monthly payments, the Fixed-COFI  mortgage also would determine how the borrower’s fixed payments would  be allocated, including to the equity savings account. The borrower’s fixed  monthly payment would be fully amortizing and be calculated based on  prevailing rates for a 30-year fixed-rate mortgage at the time of loan  origination. But the interest portion of the payment due to the lender  would be separately calculated each month, based on a rate derived from  COFI plus a gross margin to account for lenders’ costs and insurance risk  premiums. Each month, the difference between the borrower’s fixed  payment and interest due the lender based on the COFI rate plus a gross  margin would determine if any funds from the borrower’s payment would  be added to the equity savings account.

The funds allocated to the equity savings account are designed to be  used to pay down the principal. However, the ways in which the home  equity funds could be used to pay down mortgage principal depend on  the terms of each loan. If the home equity account were depleted, lenders  might cover any payment shortfalls and seek insurance reimbursements.  In addition, the accelerated equity-building effect of the Fixed-COFI  mortgage product would rely on the historical difference between the  COFI rate and 30-year fixed rate (see fig. 5). If the difference between the  rates narrowed, the savings allocated to the equity savings account would  lessen, and equity-building effects would be reduced. That is, in months  in which the COFI rate plus the gross margin was lower than the 30-year  fixed rate used to calculate the monthly payments, the difference between  the COFI-based and fixed amounts would be deposited into a home  equity savings account. In months in which the fixed payment would not  cover the interest payment (because the COFI rate plus the gross margin  is higher than the 30-year fixed rate used to calculate the fixed monthly  payment), funds could be withdrawn from the equity savings account to  cover any shortfall. If the equity savings account had a zero balance, the  lender could seek an insurance payout.

According to the economists, some details of the Fixed-COFI contract can  be modified for different rules concerning refinancing and savings. For  example, a borrower and a lender can agree to how and when funds in  the home equity savings account could be applied to pay down the  mortgage principal. However, the Fixed-COFI mortgage contract would  place limits on a borrower’s options to refinance—for instance, only in the  case of the loss of a job—because it is designed to protect borrowers and  lenders from fluctuations in interest rates.

If interest rates drop significantly, benefits from the rate decrease for a  borrower with a Fixed-COFI mortgage would be limited as compared with  the benefits of a borrower with a 30-year fixed-rate mortgage who  refinances. For example, the additional savings from lower interest rates  for the borrower with a Fixed-COFI mortgage could only be used to pay  down the mortgage principal. In contrast, although refinancing has costs,  borrowers with a traditional 30-year fixed-rate mortgage would be able to  refinance to take advantage of the lower rate and reduce their monthly  payment. They could use the resulting difference in monthly payments  from the new, refinanced loan to pay down mortgage principal, build up  savings, or for any other purposes.

Advantages of Accelerated Home Equity Building Include a Financial Safeguard

For some homeowners, building home equity faster can provide financial  benefits. Home equity can serve as a financial asset to fund retirement,  education expenses, or absorb financial emergencies like the loss of a  job. All else being equal, having more home equity also can help sustain  homeownership through a downturn in the housing market. For example,  default rates are generally higher for loans with higher loan-to-value (LTV)  ratios.

Although some accelerated equity-building options are designed to be  originated with high LTV ratios (in some cases exceeding 100 percent),  the accelerated equity-building effect can lower the LTV ratio at a faster  pace than for a 30-year fixed-rate mortgage. As shown in figure 6,  according to our analysis, LTV ratios can converge after about 5 years for  a 15-year fixed-rate mortgage with a high LTV and a 30-year fixed-rate  mortgage with a higher down payment. More specifically, in about 5 years  a 15-year fixed-rate loan with an LTV ratio of 103 percent at origination  will reach the same LTV ratio as a 30-year fixed-rate loan with an LTV  ratio of 80 percent at origination. Borrowers under both mortgage  scenarios would have accrued close to 30 percent equity in about 5  years, assuming no change in the home’s value.

Lenders and proponents of accelerated equity building with whom we  spoke said that having substantial equity in a home provides more  options for remediation in the event the homeowner encounters difficulties  making mortgage payments. For instance, a lender with whom we spoke  said that having more equity in a home provides a borrower with a better  opportunity to refinance to get a better interest rate and also extend their  loan term, both of which would lower their monthly payment. Two lenders  with whom we spoke also said that accelerated equity-building options  can provide financial discipline and serve as a forced savings mechanism  by, for example, paying additional principal on the mortgage. In addition,  proponents of accelerated equity building have suggested that  homeowners with more equity at stake may have more incentive to stay  in their home because they have more invested in the home.

In addition to building equity, borrowers with shorter-term mortgages or  those opting to make extra payments on 30-year mortgages would reduce  overall loan expenditures—relative to the interest they would pay on a 30- year loan (see fig. 7). However, the overall higher mortgage payments  can make these options less affordable for lower-income borrowers or  limit financial flexibility, as discussed below.

Trade-offs for Home Buyers and Homeowners Include Limited Access to Shorter-Term Loans and Reduced Affordability

Accelerated equity-building products, such as a 15-year fixed-rate  mortgage or a WBHL, may not be accessible for all borrowers, partly due  to tighter credit requirements. Officials from a state housing finance  agency told us that minimum credit score requirements for some WBHLs  limit access for borrowers with lower credit scores, which includes many  lower-income borrowers. For example, a private mortgage insurer for  WBHLs requires a minimum credit score of 680, compared with the  minimum for the state housing finance agency of 640 for 30-year fixed- rate mortgages. The average score for WBHLs insured by the private  mortgage insurer is 749.

Moreover, requirements for a minimum debt-to-income ratio may also  limit lower-income borrowers’ ability to access WBHLs or 15-year fixed- rate loans. According to a private mortgage insurer, the average income  of borrowers for WBHLs it insures is 177 percent of county median  income. As mentioned previously, the QM rule generally requires home  buyers to have a debt-to-income ratio of 43 percent or less. As we  previously reported, although QM regulations are not expected to  significantly affect the overall mortgage market, some researchers have  estimated that QM regulations could adversely affect certain lower- income home buyers, particularly those living in high-cost areas. The  higher monthly payments of shorter-term loans can result in debt-to- income ratios significantly above the 43 percent limit, as illustrated in  table 3.

In areas where housing costs are high, research suggests that lower- income home buyers are more likely to have high debt-to-income ratios.  Higher monthly payments for accelerated equity-building mortgages could  make some of these borrowers ineligible for those types of loans, or  essentially limit those borrowers to significantly smaller loans, as  discussed in the following section.

Reduced Affordability and Financial Flexibility

The biggest barrier to homeownership is affordability, which includes  having enough savings for a down payment as well as sufficient monthly  income to sustain a mortgage, according to agency officials and  stakeholders with whom we spoke. For example, 53 percent of adults  were unable to save any money in 2016 and 13 percent of adults had  difficulty paying their bills at least once in 2016 because of income  volatility, according to the Federal Reserve. For the same loan amount,  the monthly payments of a 15-year mortgage can be more than 40  percent greater than the monthly payments of a 30-year mortgage,  depending upon the current market interest rates. The higher monthly payments may make shorter-term loans unaffordable for many low- income home buyers or leave borrowers with less discretionary income to  cover other obligations, including paying off higher-interest debt, putting  some of them at greater risk of defaulting on monthly mortgage  payments.

The higher monthly payments of shorter-term loans thus reduce  homeowners’ financial flexibility. In contrast, experts and stakeholders  highlighted the greater flexibility a 30-year mortgage affords homeowners,  including for situations where individuals may experience instability or  fluctuations in their income. For example, though some home buyers may  have adequate income over the course of a year to afford monthly  mortgage payments, fluctuations in monthly income can affect a  homeowner’s ability to sustain a higher monthly mortgage payment.  However, a 30-year fixed-rate mortgage may enable a homeowner to  make additional payments to build equity faster and still maintain a lower  monthly payment than a 15-year mortgage. As shown in the scenario in  figure 7 above, a homeowner could pay off a 30-year mortgage in 15  years by making additional monthly payments.

The higher monthly payment required of a shorter-term mortgage can  reduce a home buyer’s purchasing power. As seen in table 4, a longer- term mortgage allows for a substantially higher home purchase price for  the same monthly payment for principal and interest.

Borrowers are likely to qualify for smaller loan amounts for shorter-term  mortgages because of the effect of the higher monthly payments (of  shorter-term mortgages) on their debt-to-income ratio. Some proponents  of accelerated equity-building loans advertise that the monthly payment  amounts of shorter-term and 30-year fixed-rate mortgages are  comparable, with minimal loss in purchasing power. This might be the  case if the loan amount for the shorter-term mortgage were less than the  loan for the 30-year fixed-rate mortgage, as illustrated in table 4.  However, determining loss of purchasing power based on the monthly  payments of two mortgages with different loan amounts may not provide  an equivalent comparison.

Shorter-term mortgages can reduce lifetime wealth. This is because the  difference between the higher monthly payments and the monthly  payments of a 30-year mortgage could have been invested elsewhere to  produce a higher return—assuming an individual has the financial  knowledge and discipline to invest the funds. The higher required  monthly payments of a 15-year mortgage can ensure a larger investment  in home equity. However, some research suggests that, depending on  market conditions and the risk appetite of a homeowner, purchasing a  house with a 30-year fixed-rate mortgage can provide a higher lifetime  return on investment compared to a 15-year fixed-rate mortgage because  the difference between the monthly payments can be invested at a rate of  return that likely would be higher than the difference in mortgage interest  rates between 30- and 15-year mortgages.

In addition, homeownership may not always be the most effective means  of building household wealth. For example, in some circumstances  individuals may achieve greater household wealth through renting rather  than buying a home. Individuals for whom rental payments would be less  than mortgage payments for a comparable home can invest the  difference and build greater wealth—if the return on their investment  exceeded the return associated with the appreciation of the value of a  home. However, factors such as an individual’s financial literacy and  risk tolerance, and overall market conditions can affect the success of any  investment strategy, including investing in a home or in any alternatives.

Trade-offs for Lenders Include Market Uncertainty

For lenders, shorter-term mortgages generally reduce credit risk—the  likelihood of loss with default—compared with longer-term loans. In  addition, lenders with whom we spoke said that borrowers choosing  shorter-term loans (such as WBHLs) generally have good credit and high  incomes, further reducing credit and default risk. However, market  uncertainties related to the lack of a secondary market and performance  data could limit lenders’ willingness to offer accelerated equity-building  products.

Products like WBHLs are not currently eligible for purchase by Fannie  Mae and Freddie Mac. According to Fannie Mae and Freddie Mac,  WBHLs are not currently traded in the secondary mortgage market  because of factors such as the low volume of transactions and the high  LTV ratio.

Lenders with whom we spoke who offer WBHLs generally have been  holding the loans in their own portfolio, which can expose them to credit  risk and interest-rate risk. Some of the lenders told us they only offer  adjustable-rate WBHLs, to reduce interest-rate risk. But homeowners  could experience a rate shock when the interest rate adjusts. For  example, according to our analysis, if a WBHL for $250,000 adjusted the  interest rate after 7 years, the monthly payment could increase by more  than $200 (13 percent). The rate adjustment also might increase credit  risk for lenders, because some borrowers then might be less able to  sustain the monthly payments.

Some lenders may be unwilling to take on these risks, which could limit  the availability of accelerated equity-building mortgages in the market.  However, lenders with whom we spoke have been exploring options to  sell loans that have “seasoned”—for example, after the LTV ratio of the  loan reached 97 percent—on the secondary market.

Mortgages with LTV ratios of 96.5 percent or more (those that have 3.5  percent or less in down payment) also would be ineligible for some  federal guarantee programs. Generally, high-LTV loans have a greater  risk of default, and lenders with whom we spoke who offer WBHLs all  require private mortgage insurance for those loans. Lenders and private  mortgage insurers may price WBHLs at a premium—for example, through  higher fees, interest rates, or insurance premiums—to account for the  risk, which may add to the costs of monthly payments and make these  mortgages less affordable for some borrowers.

Because WBHLs are new (introduced in 2014) to the marketplace, there  are not enough data on loan performance to adequately assess payment  delinquency and default risk. The number of lenders currently offering  WBHLs is limited. According to the American Enterprise Institute, about  $100 million of WBHLs have been originated since 2014. Mortgage  insurers with whom we spoke provided a similar estimate.

Lenders told us that the performance of their WBHLs is strong but may  not offer a meaningful indicator of future performance if the loans were to  become more widely available (because WBHLs currently tend to attract  less-risky borrowers). According to lenders and housing experts with  whom we spoke, performance data on similar loans, such as fixed-rate  15-year mortgages, cannot be readily used to project performance for  WBHLs because WBHLS are not strictly comparable (they have higher  LTV ratios).

Other Trade-offs Include Limited Promotion and Adoption Due to Product Complexity

Stakeholders, including agency officials, also identified key trade-offs and  considerations in introducing new products and mechanisms to  accelerate equity building, such as how product complexity and reduced  market liquidity could affect the success and the costs to borrowers of the  products or mechanisms. These trade-offs and considerations apply to  proposed products such as the Fixed-COFI as well as to actions or  mechanisms for accelerating equity building, such as making mortgage  payments on a biweekly basis and paying off a percentage of the loan  principal in a shorter term (such as financing 20 percent of the principal in  5 years).

Some stakeholders said that new products that have unfamiliar or  complex features, such as the Fixed-COFI mortgage’s underlying  adjustable rate and equity savings account, could be difficult for lenders,  borrowers, and investors to understand, which could limit the promotion  and adoption of such products. In addition, administering new products or  mechanisms to accelerate equity building could have additional  complications, such as how to schedule and credit biweekly payments.  For example, lenders or servicers may not have a structure in place to  properly credit additional payments on a biweekly basis and may hold the  extra payment until the end of the month, negating the accelerated equity- building effect of the extra payment. Moreover, a few stakeholders said  that lenders or servicers may charge additional fees for processing  biweekly mortgage payments.

Stakeholders and agency officials also noted that any new mortgage  product would not (at least initially) be eligible for securitizing and trading  in the secondary market. As a result, a new product would not be as liquid  as current products securitized and sold in the secondary market by  Fannie Mae or Freddie Mac, such as 30-year fixed-rate mortgages.  Because of the lack of market liquidity for new products, lenders may  charge a premium, making the products less affordable for lower-income  borrowers.

We provided a draft of this report to HUD, FHFA—and FHFA also  provided copies to Fannie Mae and Freddie Mac, FHLBanks, Agriculture,  and VA for their review and comment. HUD, FHFA, FHLBanks, and  Agriculture provided technical comments on the report draft, which we  incorporated where appropriate.

We are sending copies of this report to appropriate congressional  committees, the Secretary of HUD, the Director of FHFA—who provided  copies to the President and Chief Executive Officer of Fannie Mae and  the Chief Executive Officer of Freddie Mac, the President of the FHLBank  of Des Moines (coordinating for the FHLBanks), the Secretary of  Agriculture, the Secretary of Veterans Affairs, and other interested  parties. In addition, the report is available at no charge on the GAO  website at http://www.gao.gov.

If you or your staff have any questions about this report, please contact  me at (202) 512-8678 or GarciaDiazD@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made key contributions to this  report are listed in appendix III.

Appendix I: Objectives, Scope, and Methodology

This report describes (1) how federal homeownership assistance  programs affect home equity building, and (2) options, including private- sector mortgage products, through which borrowers can accelerate home  equity building and the trade-offs of these options for both borrowers and  lenders. We define accelerated equity building as any mortgage product  or feature that accelerates the pace of principal reduction on a mortgage  debt, relative to a 30-year fixed-rate mortgage. We used the 30-year  fixed-rate mortgage as our point of comparison because it is the most  common type of mortgage product and represents the market standard.

To describe how federal homeownership assistance programs affect  home equity building, we reviewed relevant federal statutes, regulations,  and agency program policies and guides and other resources to identify  relevant homeownership assistance programs from the Departments of  Housing and Urban Development (HUD), Veterans Affairs (VA), and  Agriculture (USDA); and Fannie Mae, Freddie Mac, and the Federal  Home Loan Banks (collectively, the enterprises). We reviewed prior GAO  reports on federal homeownership assistance programs and the U.S.  housing finance system. We also reviewed relevant academic papers  and literature discussing homeownership and equity building.

We interviewed agency and enterprise officials to discuss the relevant  homeownership assistance programs and policy goals, including the  extent to which products or mechanisms used in the programs affect or  accelerate home equity building, and the role of the secondary mortgage  market in providing market liquidity for new mortgage products. In  addition to federal agencies and the enterprises, we interviewed officials  from two state housing finance agencies. Some stakeholders we  interviewed recommended the two state housing agencies because the  agencies likely placed a greater focus on accelerating home equity  building.

To describe the options (or mortgage products) borrowers have to  accelerate home equity building, including any trade-offs, we used  databases such as ProQuest and searched for and reviewed papers and  literature published from 2007 to 2017 by individuals who discussed  options to accelerate home equity building. We also attended two housing  conferences and met with housing experts and stakeholders from  academia, housing advocacy organizations, and industry, including  mortgage lenders and insurers, selected because they made proposals to  increase homeownership or build home equity faster, wrote on  homeownership issues, were recommended by government officials, or  were involved in providing mortgage products designed to accelerate  equity building. From interviews with industry stakeholders and housing  conferences we attended, we identified two products: (1) the Wealth  Building Home Loan (WBHL), which has been introduced in the  marketplace, and (2) the Fixed-Payment Cost-of-Funds Index (COFI)  Mortgage, which has been proposed but is not currently offered by any  lenders.

We reviewed and analyzed relevant academic papers and literature on  the advantages and trade-offs of options to accelerate equity building. We  also conducted interviews with academics, experts, industry stakeholders  (including mortgage lenders and insurers), and organizations to discuss  advantages and trade-offs of accelerated equity-building products, and  the role of the secondary market in providing market liquidity for new  mortgage products. We selected academics, experts, and industry  stakeholders and organizations who proposed accelerated equity-building  mortgage products, had written on homeownership and wealth building  issues, or whom officials of federal agencies and the enterprises or our  other interviewees recommended. We also attended housing  conferences, which provided additional suggestions for publications to  review and academics and stakeholders to interview.

Furthermore, to illustrate methods to accelerate home equity building and  compare the effects of different mortgage products on home equity  building, we developed hypothetical mortgage scenarios. For the  mortgage scenarios, we used Excel’s payment function to calculate the  amortization schedule of the mortgages in our hypothetical scenarios.  The payment function is a standard formula that calculates monthly  payment schedules based on inputting interest rate, number of payment  periods over the life of a mortgage, and the present value of the  mortgage. The scenarios we developed were only several possible  scenarios out of the many that we could have chosen. We identified  specific mortgage features in papers and literature by individuals who  proposed mortgage products designed to accelerate home equity  building. For illustration purposes, we used an average of the monthly  interest rates published in Freddie Mac’s Primary Mortgage Market  Survey for September and October 2017, as well as current market rates  advertised by private mortgage lenders, to inform our selection of interest  rates for our scenarios.

Appendix II: CoreLogic Home Equity Data, by State

This appendix provides regional data on equity building that we obtained  from CoreLogic. CoreLogic is a publicly traded company that provides  data, analytics, technology, and services related to the mortgage industry,  among other things. The data in figure 8 show the percentage of  homeowners in each state who have 20 percent equity or less in their  homes. The level of home equity can be affected by a number of factors,  including the age of the loan, the amount of principal paid down, and  home market values. We did not assess the reliability of CoreLogic’s  data.

Appendix III: GAO Contact and Staff Acknowledgments

In addition to the contact named above, Andrew Pauline (Assistant  Director), Kun-Fang Lee (Analyst in Charge), Steve Brown, Raheem  Hanifa, Jeff Harner, Jill Lacey, Barbara Roesmann, Jessica Sandler,  MaryLynn Sergent, Jena Sinkfield, Anne Stevens, and Jim Vitarello made  key contributions to this report.