Economics, Financial Services

The Dark Side of the 30-Year Fixed-Rate Mortgage

American discussions of housing finance give a shining religious aura to 30-year fixed rate mortgages (FRMs). They provide the last refuge of the defenders of Fannie Mae and Freddie Mac, who argue that we have to have government guarantees so we can have 30-year FRMs. First, this argument is not true; and second, the 30-year FRM is not the unmitigated blessing the Fannie and Freddie loyalists imply. Indeed, one of the key reasons U.S. mortgage markets are in such bad shape today is precisely the 30-year FRM.

No instrument is universally good in all times and all economic situations. Let us consider not only the advantages, but also the dark side of the 30-year FRM. For borrowers of 30-year FRMs, the advantageous situation is when interest rates are rising and house prices are rising. Then the borrowers have the same mortgage payments in spite of rising interest rates, and they get to keep the whole inflationary premium in the house price. This is the bright side.

But suppose interest rates fall to very low levels, and house prices are also falling. Needless to say, this is the reality of the last few years, and it brings out the dark side. Then the borrowers often cannot refinance because of the fall in house prices, so they are stuck with what is now a very high nominal and even higher real interest rate, and their payments stay the same in spite of falling interest rates. The entire deflationary discount in the house price is imposed on them. Defaults rise; house prices are pushed further down.

In this situation, it becomes quite difficult to modify the 30-year FRMs which cannot be refinanced, as the many government modification programs have demonstrated. In contrast, a floating rate mortgage, say of the typical British variety, does not need to be modified: the interest rate automatically falls with market rates. This relieves the cash payment burden on the borrowers and shares the deflationary discount with the lenders.

Of course, American mortgage borrowers and lenders did not expect house price deflation and interest rates near zero, but they got them anyway, in large part because they believed in house price inflation. No loan is the best for all seasons.

Image by Chris Short.

Comments are closed.