Can there be too many homeowners?
By Greg McBride, CFA • Bankrate.com

More than 69 percent of American households own their homes. Further expanding the rate of homeownership, which is a policy shared by the housing industry and politicians alike, is leading to an increased focus on subprime borrowers -- those with less-than-perfect credit.

But with affordability for first-time home buyers already quite low, will the current initiatives aimed at creating even more homeowners backfire?

An index of affordability for first-time home buyers shows a disconnection between the prices of starter homes and the income of first-time buyers. With the number 100 indicating that a median-income first-time buyer has exactly the income needed to buy a median-priced starter home, the current first-time home buyer index of 74.7 is cause for concern.

According to the National Association of Realtors, 40 percent of home buyers are first-time buyers. The era of ultra-low mortgage rates has introduced many households to the world of homeownership. With interest rates remaining so low for so long, what will it take to expand homeownership above the current 69-percent threshold?

The growth in the mortgage market will be among subprime borrowers, those without credit or with previous credit missteps. Among Freddie Mac, Fannie Mae, and the Department of Housing and Urban Development (HUD), a push is under way to develop products for subprime borrowers to facilitate homeownership, despite current affordability issues and low interest rates.

The quarterly home affordability press release by the National Association of Realtors contains a revealing statement. "However, many buyers are making smaller down payments than assumed by the index, and are using loans that give them more buying power." Therein lies the problem.

According to Fitch Ratings, hybrid mortgages that offer an initial fixed rate for five years or more perform similarly to fixed-rate mortgages in terms of delinquency and default. Hybrids with a fixed period shorter than five years, such as a 3/1 ARM, have higher instances of delinquency, even in the initial years of the loan prior to the first reset. In general, the shorter the initial term, the lower the mortgage rate. That makes one-year ARMs and 3/1 ARMs particularly appealing to those with limited income.

Mortgage delinquency crops up most often three to five years after the loan is taken out. The statistics show that those choosing 3/1 ARMs -- many doing so on the basis of affordability -- are more inclined to fall behind, even on jumbo products. According to the Mortgage Bankers Association, default rates for ARMs are higher than fixed loans, even in a declining rate environment.

What does this mean? Affording the home on closing day is not necessarily an indicator of ongoing affordability. Does targeting subprime borrowers in a bid to expand homeownership create more problems than it solves?

Look no further than a few unsettling trends and you may want to reach for the antacid. The household savings rate is a dreadfully low 0.2 percent of disposable income, indicating many households lack an adequate safety net in the event of unplanned expenses. I venture to say this is particularly relevant to subprime borrowers, with their credit ratings having suffered from similar circumstances in the past even without the added burden of homeownership. Insufficient savings means many of these new home buyers will make low or no down payments on their new home. With such a small initial equity stake, the risks of rising mortgage rates and slower home price appreciation in the future are especially dangerous for borrowers opting for ARMs or interest-only mortgages based on affordability.

Imagine the impact on a household that stretched to buy a home, with little safety net beneath them, in the event of a prolonged layoff or illness. Then also imagine -- as most economists do -- that rates continue to rise while home appreciation slows. Will the homes purchased under home buyer initiatives in the middle of this decade become foreclosures late in the decade?

When a similar question was raised at the Mortgage Bankers Association Annual Convention in October, the discomforting answer provided was, "Time will tell."

Earlier that week at the same convention, Richard Syron, chairman and CEO of Freddie Mac, acknowledged the risk ahead, saying, "We have to help people buy and keep homes."

First-time buyers must be even more cautious about buying and keeping the home before making a commitment to homeownership. After all, lenders aren't bearing the bulk of this risk. Most lenders sell their loans to investors, and many of these loans are guaranteed by government-sponsored entities such as Fannie Mae and Freddie Mac.

Borrowers, on the other hand, remain on the hook, no matter who holds the loan.

Greg McBride is a financial analyst for Bankrate.com.

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