How Would Replacing 30 year Mortgages with 10 Year Mortgages Accelerate Climate Change Adaptation Through Protecting Real Estate?
Imagine!
U.S home buyers expect that they can finance a home purchase with a fixed rate 30 year mortgage. In an increasingly risky world featuring interest rate risk, natural disaster risk, macro economy risk, local and regional economy risk, and local quality of life risk, why would borrowers continue to expect that banks will be happy to quote you an interest rate today and “lock in” and let you hold an option for the next 30 years to decide if you will or will not continue to make your mortgage payments?
Suppose that lenders retreat and only offer 10 year mortgages. This entry explores the climate change adaptation benefits of such a new rule of the game.
Suppose that the lender is worried about natural disaster risk for the risk that the home’s area tends to face. Some homes will be in areas that flood while others will be in fire zones. Suppose that the lender offers a bundle of a fixed rate mortgage and an insurance premium whose rate rise over time is tied to destruction in the home’s zip code. This zip code trigger avoids moral hazard effects by the home owner and it protects the insurer from locking in to a low rate in an area that subsequently faces more physical risk than the actuaries anticipated ex-ante.
By offering a bundle of insurance and the mortgage loan contract, the lender could incentivize home upgrading to reduce physical risks from flooding and fires. The lender could offer a lower interest rate and a cheaper insurance premium if the home buyer takes verifiable steps to make the home more resilient to local disaster risk.
The home buyer would face higher mortgage payments for the home with a 10 year loan rather than a 30 year loan. The mortgage payments would mean that the home buyer would quickly have more “skin in the game” in terms of housing equity (current home value - mortgage still owed) and would be less likely to default on the mortgage.
UPDATE: Home buyers who buy with a 10 year loan would anticipate that they will have more “skin in the game” and will invest more upfront effort in doing their “due diligence” about a property’s risks. They will research topics such as future flood and fire risk. Behavioral economic theories of “dumb asset buyers” will do a worse job predicting mistake making because decision makers will think through their decisions.
Under the 10 year mortgage, the home buyer would have a key choice. Either she can save up more money to have a lower loan to value ratio or she could partner with a management company to own 1/2 of her house. This book explores this latter option.
Many household finance economists argue that home owners are “amateurs” who do not optimize in managing their assets. If home buyers brought in professional management team to finance their investment, this entity would have the capital, human capital and experience and data to coach the family concerning how to manage the asset.
The management company WOULD NOT live with the home owner. Instead, they would own 1/2 of the asset and would receive 1/2 of the sales price when the home is sold or would receive 1/2 of the rental stream if the home is rented out.
An Empirical Hypothesis
I posit that if more homes were owned under this incentive structure that in the aftermath of future natural disasters striking a specific area that homes in this area owned under the contract design I have sketched would be less likely to be damaged, and there would be fewer defaults on mortgages and claims placed on insurers.
The climate damage function would flatten due to this change in contract design. This is the Climate “Lucas Critique” that I discuss at length in my 2021 Yale University Press book.
Under these rules of the game, home builders would also start to build different homes. They might build less durable homes in risky areas to give real estate owners a real option to demolish the remaining structure and to rebuild using better materials. They might also build with modular material that can be disassembled so that the capital could be salvaged and used in another location. We discuss this in our 2017 paper.
So many analysts of the climate challenge ignore basic ideas from microeconomics. Give markets a chance to help us to adapt! This is my main research agenda going forward.