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March 11, 1991
"Un-crunching Home-buying - Acknowledging Inflation puts More Mortgages within Reach"
San Jose Mercury News

By Timothy Taylor
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IT'S TOUGHER for this generation to buy a home.

Since 1973, the median price of an existing U.S. home has risen about 22 percent. However, median household income has risen a bare 2 percent faster than inflation over that time. (The "median" is the amount that half are above, and half are below.)

But if home-ownership problems are a case of the flu for the rest of the country, they're walking pneumonia here in Santa Clara County. Although the median household income in this county is about 60 percent above the national median, the higher incomes don't compensate for fact that the median-priced home in Silicon Valley costs more than double the national median price.

To make matters even worse, borrowing for a home mortgage has become more expensive, too. The typical new home mortgage was a shade under 8 percent in 1973; by 1990 it was around 10 percent.

There are no quick fixes for the triple-whammy of higher housing prices, higher interest rates and incomes that don't rise much. But two economists, Joe Peek of Boston College and James A. Wilcox of the University of California, have a suggestion for a new kind of mortgage that would allow home- buyers to afford more home with their existing income. They call it the price-level adjusted mortgage, or PLAM, and describe it in the most recent issue of the New England Economic Review.

To understand the PLAM, first consider this odd fact about a typical fixed-rate mortgage: Although the homeowner may seem to be making a fixed monthly payment, the real value of that monthly payment is actually declining over time.

As an example, consider a family with $80,000 per year in income and monthly mortgage payments of $2,000. If the family income just keeps up with a 5 percent rate of inflation for 30 years, the family will be making $345,000 in year 30, even though the buying power of its income hasn't increased at all.

Obviously, it will be a lot easier to make those $2,000 mortgage payments as time goes on, with inflation pushing up the dollar amount of the family income and pushing down the real value of the mortgage payments.

Rise with Inflation
A PLAM takes a different approach. Instead of having fixed dollar payments, which mean the highest real payments now and gradually lower ones as inflation takes its toll, price-level adjusted mortgage payments would rise with inflation, keeping the same real value.

Because PLAM payments would be considerable higher than fixed mortgage payments in the future, the first year's worth of PLAM payments would be considerably lower -- perhaps one- third lower. For example, the hypothetical family mentioned earlier might start with a $1,500 payment today, but if inflation averages 5 percent, the family would be agreeing to pay $6,500 per month in the 30th year of the mortgage.

With its lower initial payments, a PLAM would allow a family of a given income to afford more house. As long as the home- buyer's income rises with inflation, the PLAM adjusts mortgage payments to the ability of the family to pay.

A PLAM is very different from an adjustible-rate mortgage. After all, payments with an adjustible-rate mortgage can either be fairly steady or jump about, depending on how interest rates shift. But adjustible-rate mortgage payments don't increase steadily with the rate of inflation, like a PLAM.

Internationally Tested
The price-level adjusted mortgage is an internationally tested idea: According to Peek and Wilcox, it is used in Canada, Australia, Finland, Israel, Brazil, Colombia, Paraguay, Peru and other nations. Why not the United States?

For most borrowers, the main problem with a PLAM is that it requires thinking in inflation-adjusted terms. You must face scheduled mortgage payments 30 years from now that may appear outlandishly high, but are only the result of a moderate inflation rate over three decades.

Moreover, because of the lower initial payments of a PLAM, a homeowner would accumulate equity much more slowly. Although the real value of the money owed will decline steadily with a PLAM, the number of dollars owed may rise for the first few years. For example, the borrower may take out a mortgage loan for $200,000, but owe $205,000 at the end of the first year. However, if inflation was 5 percent that year, the real amount owed has actually declined when measured in inflation-adjusted dollars.

Thinking in inflation-adjusted terms isn't obvious, but ordinary people manage it every day in countries all over the world with high rates of inflation. If understanding inflation makes it possible to afford a home that otherwise couldn't be bought, it's a safe bet that more people would learn.

Demonstration Program
Uncertainties about how tax laws and bank regulations might be applied to PLAMs have hindered banks and other institutions from offering them in the past. But the federal government has now cleared up those uncertainties, according to Peek and Wilcox. In fact, the federal government is even considering running a demonstration PLAM program, just to show how it works.

So listen up, all you banks that keep advertising your eagerness to help people buy a home. Here's an opportunity to market a new financial product, and allow some people who couldn't otherwise afford it to become homeowners.

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