Friday, July 01, 2005

Speaking of the real estate bubble, The Volokh Conspiracy's Todd Zywicki has an, er, interesting take on "exotic mortgages" such as "interest only" mortgages, where the purchaser spends a few years only paying interest on the mortgage, before actually beginning to pay down the principal and acquire equity in the home. The problem with paying down the principal on your mortgage, he writes, is that it "would increase the covariance of your human wealth with your home equity"--that is, it causes you to invest in the same locale where you earn your income, increasing your vulnerability to a local economic downturn. (A bad local economy might cost you both your job and a chunk of the property value of your home.) Zywicki's solution: "we want to encourage individuals to minimize their principal payments on their houses and instead to diversify that money into financial assets that will diversity [sic] away from the risk associated with human capital."

Well, there's a perfectly reasonable, long-accepted way for households to "minimize their principal payments on their houses and instead to diversify that money into financial assets that will diversity [sic] away from the risk associated with human capital." It's called, "renting". Holders of interest-only mortgages, on the other hand, pay a premium--usually a hefty one--over the market rent for the same property. That premium in effect purchases an option to buy the house at a later date at a fixed price. (After all, until the mortgage-holders start paying the principal, they don't actually own any equity in the house.) This option is purely speculative: it amounts to a bet that the same house will be more expensive to buy once the principal payments start. If house prices stay constant, then the difference between the interest paid and the cost to rent an equivalent house during the "interest only" period will have been completely wasted.

It's true that a mortgage is always an investment on margin, and hence at least partly speculative. But option plays such as interest-free mortgages are purely speculative, and one wonders what ordinary householders are doing engaging in them--or what supposedly economics-savvy law professors like Zywicki are doing endorsing them.

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