Housing Affordability: Leverage and Risk

Abstract

The housing affordability area covers a large scope as it deals with two different aspects of the topic, the definition from endless sources from the literature and the measurement of the defined subjects. In this thesis the two affordability measurements chosen and defined, the purchase affordability and the repayment affordability, will be explained and used in a sensitivity analysis made on different mortgage types chosen from the Danish mortgage loan market. The strongly related parameters when considering affordability, leverage and risk, will be discussed and it will be demonstrated that those parameters are extremely important when discussing housing affordability. The relationship between those factors is complicated and double sided as it at the same time can indicate increased and decreased affordability. The additional costs and benefits of homeownership must be taken into concern when analyzing the concept of housing affordability. Taxes and user cost will therefore be discussed as they have great influences at the affordability measurements and possible incentives to increase leverage and risk. Together the factors mentioned above are related to the borrower’s risk of defaulting on his mortgage loan. In this aspect two theories of default, the equity theory of default and the ability to pay theory of default will be considered and used as a guide in an attempt to understand whether borrowers react to purchase affordability or repayment affordability when considering their loan structure and leverage, and as a result whether their base default decisions is on equity or repayments. The relevance of consumption, savings and house price fluctuations is present when considering the borrower´s risk of defaulting as the housing wealth is the largest single component of his total wealth. Through loosened credit constraints and changed legal framework making equity withdrawal easier for homeowners, the initiatives to increase consumption by higher leverage must be examined not least in Denmark where Danish households are the most indebted households in the world. Consequently, it becomes relevant to take a look at which loans the Danish homeowners prefer, to analyze the cost of mortgage loans at the market today and the risk involved. Furthermore it will be shown that for the owner-occupiers who do not borrow to finance their homeownership the risk is relevant, not at least when taking into concern their temptation to withdraw equity and join the group of homeowners who are exposed to the risk of defaulting on their loans.