Maxwell J. Fry

English

Research Papers in Economics

July 11,1980 
Mo  gage Innovation? 
A recent survey by the U.S. League of  Savings 
Associations showed that San Francisco has 
the highest housing costs among the 20 larg-
est metropol itan areas, with an average 
(mean) of  $90,000 for single-family houses in 
the second quarter of 1979. But San Fran-
cisco is a distant second to another area-
Honolulu County (which covers the island of 
Oahu)-with its $144,000 average price for 
single-family houses in 1979. This raises the 
question of how Hawaiians can actually af-
ford to live in Hawaii. But it also raises the 
broader issue of how inflation and heavy 
population pressures jointly affect home 
prices in booming Sunbelt communities 
and how the mortgage-finance industry can 
cope with the problem. 
Inflation and mortgage rates 
In the good old days of price stability (circa 
1955), one might have obtained a mortgage 
in Hawaii (or elsewhere) at an interest rate of 
around 3 percent. By 1970, mortgage rates 
had risen to 9 percent. But in April 1980, rates 
ranged as high as 17 percent and indeed, it 
was difficult to find a conventional mortgage 
at any price. Mortgage rates have now fallen 
to 12-13 percent, but many analysts predict 
that they will rise again when the economy 
recovers. 
The direct cause of  this rate escalation has 
been inflation. Consider a lender subject, at 
the margin, to a 30 percent tax rate. To obtain 
a 2-percent real (inflation adjusted) after-tax 
return on his/her loan, the lender must charge 
a nominal, gross interest rate of 2.86 percent 
when there is no inflation, 10.14 percent 
when the inflation rate reaches 5 percent (as it 
did in 1970), and 17.43 percent when the 
underlying inflation rate hits 10 percent (as it 
has in 1980). With this schedule of rates, a 
lender would be unaffected by inflation, and 
so presu mably wou  Id be prepared to lend the 
same amou  nt i  rrespecti ve of  the actua I rate of 
inflation. 
The only hitch is that the borrower finds it 
very difficultto pay such astronomical mort-
gage rates, especially when applied to astro-
nomically rising home prices. Consider the 
case of an experienced Honolulu public-
school teacher, with a salary of $18,807 for 
the coming academic year-i.e. $1,567.25 a 
month -subject, at the margin, to a 30 per-
cent (federal plus state) taxrate. Under the 
typical rule of  thumb, with payments equal-
ling no more than 25 percent of income, our 
public-school teacher will be allqwed a max-
imum mortgage payment of $39'1.81  a 
month. That means that the borrower can 
obtain $94,655 at a gross nominal interest 
rate of 2.86 percent-but only $44,126 at a 
1  0.14-percent rate, and a mere $26,825 at a 
17.43-percent rate. The higher the mortgage 
rate, the smaller the loan. Clearly, then, the 
borrower is far from indifferent about the rate 
of inflation and its effect on the nominal rate 
of interest. 
Housing costs and income 
Our teacher's plight may be illustrated in an-
other way. In 1970, if  ourteacher had wanted 
to buy an average ($50,000) house with a 
9-percent mortgage and 25-percent down, 
his/her monthly payments would have been 
$301.73 for a 30-year'loan. An experienced 
teacher with a $946.1 O-a-month salary in 
1970 would have been entitled to a $236.53-
month mortgage payment, enabling him/her 
to borrow $29,396 or 59 percent of the pur-
chase price. 
In 1980, in contrast, if  our Honolulu teacher 
wants to buy an average (now $150,000) 
house with a 16-percent mortgage and 25-
percent down, his/her monthly payments 
would be $1,512.85 a month. But as we have 
seen, the typical lender in Hawaii would 
allow a maximum monthly payment of only 
$391.81  a month. At 16-percent interest, this 
monthly payment raises a loan of $29,136, 
. which is $260 less than our teacher could 
borrow in 1970, despite the 66-percent rise in ,L 
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the salary scale since then. In 1980, our 
teacher can borrow only 19 percent of  the 
purchase price of  an average single-family 
home. 
Clearly, our teacher's prospects of buying an 
average Honolulu house are bleak, in large 
part because of the high nominal interest rate 
on a conventional mortgage. But, the lender 
too is worse off  with a 16-percent interest rate 
and 10 percent inflation than with a 2.86-
percent rate and stable prices. Clearly, both 
the borrower and the lender are losers from 
inflation. 
Inflation and loan maturities 
Inflation, in effect, accelerates repayment of 
the loan principal. A borrower obtains a 
30-year loan in order to spread the loan re-
payment out over 30 years, but inflation 
effectively shortens that repayment period. 
For example, the buyer of an average 
$150,000 house with a $112,500 mortgage 
loan would pay $1,643.07 a month at an 
interest rate of 17.43 percent and 10-percent 
inflation. After one year, the remaining bal-
ance outstanding on the $112,000 loan 
would be $112,381, i.e. only $119 is repaid. 
But those calculations fail to take account of 
the 10-percent inflation, which boosts the 
buyer's equity and reduces the price-level 
adjusted or "real" loan balance to $102,165-
in other words $10,335 is really paid off . 
during the first year of the mortgage. 
At 2.86-percent interest and no inflation, the 
month  Iy payment on the $112,500 mortgage 
would be $465.68. After one year, the bal-
ance outstanding would be $110,095, i.e., 
$2,405 is repaid. Thus, the borrower would 
repayoverfourtimes as much principal in the 
case of 10-percent inflation than in the zero 
inflation case. Ofcourse, the real valueofthe 
mortgage debt outstanding falls much faster 
under inflation, but this is simply because 
repayment of  the loan principal is much faster 
too. The snag is that a teacher earning 
$18,807 a year just cannot afford to repay 
mortgage principal at an annual rate of 
$10,335. 
2 
Accelerated effective repayment-the mort-
gage "tilt" effect -clearly reduces the 
attractiveness and hence the demand for 
mortgage loans. This effect is only partially 
offset by the benefit of  a shorter effective loan 
matu rity. Both lenders and borrowers are 
worse off  because, by accelerati ng the repay-
ment of principal, inflation destroys the most 
important attribute -the  30-year maturity-
of the conventional mortgage. Inflation 
weakens the capital market with its tradi-
tional financial instruments. 
PlAM: the answer? 
Fortunately, there is a simple way of solving 
this problem -i.indexing the mortgage's 
monthly payments and principal out-
standing. This financial instrument is called a 
price-level-adjusted mortgage (PLAM). The 
interest rate on a PLAM would be the real 
rate, e.g., 2.86 percent, regardless ofthe level 
of  the inflation rate. Our Honolulu teacher on 
her/his income of $18,807 a year could now 
borrow $94,655 at a 2.86 percent real rate, 
representing a more respectable 63 percent 
of  the average house price. 
Considerwhatwould happen with a PLAM in 
the event of constant 1 °  percent inflation, 
with the monthly payment and principal out-
standing increasing by 10 percent a year-
and with the homebuyer's salary and home 
value also increasing by 1 °  percent a year. At 
the end of 30 years, our Honolulu teacher 
would be earning more than $328,000 an-
nually and would own a mortgage-free home 
worth $2.2 million (see table). Other points to 
note from the table are: (1) monthly pay-
ments remain 25 percent of income through-
out the mortgage's life; (2) the nominal 
balance outstanding rises, but at less than 10 
percent a year, to reach a maximum of 
$275,838 in the twenty-first year; (3) the 
homebuyer's own equity in the house rises 
continuously from 25 percentto 100 percent 
at a rate wh  ich always exceeds 1 °  percent a 
year. 
Financial institutions in Hawaii and many 
other states, however, cannot offer PLAMs because of  federal and state regu lations. For 
example, Hawaii's state usury law, although 
amended this year, still prohibits lenders from 
charging interest on interest. The law inter-
prets an increase in the outstanding balance, 
which a PLAM involves, as postponed in-
terest payments. Thus interest cannot be 
charged on any part of  that balance which 
exceeds the original nominal value of  the 
loan -although, in the present case, the 
excess wou  Id equal 66 percent of  the balance 
after 20 years. 
The PLAM has potential advantages both to 
borrowers -larger loans and/or lower initial 
payments -and  to lenders -a  higher real i  n-
terest rate. Many legislators, bankers and 
consumer groups cannot see those advan-
tages, however, becausethey are suffering 
from a money illusion. A PLAM under infla-
tionary conditions is identical to a conven-
tional, fixed-interest mortgage under price 
stability. Perhaps the least that government 
can do in an inflationary atmosphere is to 
initiate legislative and regulatory reforms to 
permit PLAMs. Government agencies (e.g. 
Federal Housing Administration, or State 
Employee Retirement Funds) could be en-
cou  raged to pu rchase PLAMs to demonstrate 
thei  r viabi  I  ity. 
Nonetheless, PLAMs will increase demand 
for houses. If, as in Hawaii, supply is inelastic, 
the price of houses will rise yet further. Our 
teacher may be chasing a rainbow. Perhaps 
the ultimate solution to the high cost of 
housing in Hawaii is fewer people. 
Maxwell j. Fry 
(The author, Professor of Economics at the 
University of Hawaii, is Visiting Economist 
this summer at the Federal Reserve Bank of 
San Fancisco.) 
Effect of PlAM and 10-Percent hilflatBOiil 
on Salary, Mortgage and Home Value 
Year  Monthly  Monthly  Mortgage  House  Equity in 
Salary  Mortgage  Balance  Value  House 
Payment  Outstanding 
0  1,567.25  391.81  94,655  126,206  31,551 
5  2,524.07  631.02  135,175  203,257  68,082 
10  4,065.04  1,016.26  185,627  327,347  141,720 
20  10,543.67  2,635.92  274,853  849,053  574,200 
25  16,980.69  4,245.17  237,091  1,367,408  1,130,31'7 
30  27,347.58  6,836.89  0  2,202,225  2,202,225 
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BANKING DATA-TWELFTH fEDERAL RESERVE DISTRICT 
(Dollar amounts in millions) 
Selected Assets and liabilities 
large Commercial Banks 
Loans (gross, adjusted) and investments* 
Loans (gross, adjusted) - total # 
Commercial and industrial 
Real estate 
Loans to individuals 
Securities loans 
U.s. Treasury securities* 
Other securities* 
Demand deposits - total # 
Demand deposits - adjusted 
Savings deposits - total 
Time deposits - total # 
Individuals, part. & corp. 
(Large negotiable CD's) 
Weeldy Averages 
of Daily figures 
Member Bani, Reserve Position 
Excess Reserves (+ )/Deficiency (  - ) 
Borrowings 
Net free reserves (  + )/Net borrowed (  - ) 
* Excludes trading account securities. 
#  Includes items not shown separately. 
Amount 
Outstanding 
6/25/80 
136,207 
114,736 
33,242 
46,492 
23,699 
945 
6,304 
15,167 
40,935 
30,110 
27,561 
63,264 
54,467 
22,669 
Weekended 
6/25/80 
55 
1 
56 
Change 
from 
6/18/80 
31 
43 
40 
53 
0 
- 69 
- 19 
7 
-1,984 
398 
154 
- 319 
- 255 
136 
-
-
-
Weekended 
6/18/80 
73 
1 
73 
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Change from 
year ago 
Dollar  Percent 
8,038  6.3 
9,029  8.5 
2,205  7.1 
8,032  20.9 
1,299  5.8 
657  - 41.0 
1,130  - 15.2 
139  0.9 
559  - 1.3 
73  - 0.2 
2,563  - 8.5 
11,792  22.9 
11,912  28.0 
4,458  24.5 
Comparable 
year-ago period 
34 
150 
- 116 
Editorial comments may be addressed to the editor (William Burlce) or to the author ....  Free copies of this 
and other Federal Reserve publications can be obtained by calling or writing the Public Infonnation Seelion, 
federal Reserve Bank of San .Francisco, P.O. Box 7702, San  fr~ncisco 94120. Phone (415) 544-2184. 

Mortgage innovation?

http://www.frbsf.org/publications/economics/letter/1980/el80-28.pdf

Mortgage innovation?

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Research Papers in Economics