November 30, 2017

This is a hot-button issue. Many aspiring first-time homebuyers find it difficult to save for a down payment, and millennials heavily burdened by student debt find it especially challenging. There is widespread sentiment that they ought to be given a helping hand.

State-Based First-Time Home Buyer Savings Account Laws

In response, a number of states have passed laws designed to encourage saving for a down payment. These programs eliminate state income taxes on interest paid on deposits earmarked for that purpose by first-time home buyers. According to Jonathan Lawless writing in National Mortgage News of Nov. 17, such programs have arisen in Montana, Virginia, Colorado, Mississippi, Iowa and Minnesota, and are pending in Pennsylvania, New York, Oklahoma, Maryland, Utah and Louisiana.

After taking a close look at the laws in several of these states, I have concluded that they lack a key requirement of a successful savings program: savings discipline. This article describes a different type of program that does provide savings discipline, and would therefore result in a much more powerful inducement to save for a down payment. In addition, it would be national in scope, and no taxpayer funds would be required.

The Importance of Savings Discipline

Savings discipline is the imposition of a cost on those who fail to meet their savings objective. Its role is to protect savers against momentary weaknesses that can subvert their objective. The discipline can be provided in the terms of a savings program, or by the savers themselves.

The most striking illustration of self-imposed saving discipline is one I saw in Liberia some years ago, where wannabee homeowners used their savings to purchase cinder blocks, which they piled up on their land until they had enough to start building their home. They lost the interest they could have earned if they had put their savings in a bank, and their cinder blocks were subject to weather-based deterioration, but the process thwarted temptations to use their savings for something else.

Even in the US, a sizeable segment of the population finds it impossible to save without being subjected to savings discipline. Large numbers of people deliberately over-withhold on their income taxes in order to get a refund at the end of the year. The practice is particularly widespread in the US military. Most over-withholders realize that they are giving an interest-free loan to the Government, but they accept that as the price of savings discipline. Layaway plans offered by department stores, where a customer makes a partial payment for a product which is put aside for them, are very similar.

Proposal For a Privately-Based First-Time Home Buyer Savings Account Program

The core player in this proposal is a depository institution offering a new type of account – call it a down payment account or DPA. A DPA would differ from all other accounts in that interest would accrue but not be paid except as part of a home purchase, where both principal and accrued interest could be used for the down payment and to meet settlement costs. Deposits used for any other purpose could be withdrawn at any time but would receive no interest. Accrued interest would not be an expense to the depository until it was paid as part of a home purchase transaction. Government‘s only possible role is in authorizing this new type of deposit, should that be necessary.

Savings Discipline on the DPA

Those who fail get no interest while those who succeed earn enhanced interest. Because the failures receive no interest, the rate that will be offered on these accounts and enjoyed by successful savers will be higher than those on comparable standard deposits. For example, if the bank anticipates that half the deposits will receive zero interest, then it will pay 2% on an account type that would otherwise be priced at 1%.  Banks that are also mortgage lenders will be particularly aggressive in pricing these deposits because of their expectation that successful saver/home buyers may well take their mortgage from them.

Differences Between the DPA and the State Programs

The cost of failure on a DPA is loss of interest. In contrast, there is no cost of failure in the state programs because those who fail earn the same interest rate as those who succeed, and receive the tax benefit immediately. While they must repay the tax benefit at some point in the future, they are no worse off for having participated in the program.

The DPA would be available nationwide. In contrast, the state programs are limited to residents of the state purchasing properties in the state; those planning to purchase a home in a different state do not qualify.

The DPA would require no public funding. In contrast, the states will incur revenue loss, and will be faced with a formidable administrative hassle. They will have to incur the expense of getting failed savers, who may now live in other states, to repay the tax benefit.