For many decades the 30-year loan has been the centerpiece of the mortgage system, but there’s no law in nature which says 30-year financing is required or necessary. Indeed, we could we be coming to the end of an era, a new housing market where 30-year loans are as common as unicorns.
Prior to the Great Depression the typical home mortgage lasted five years and required 40 to 50 percent down. At the end of the term the borrower got a new five-year loan and all was well — unless home values fell and lenders would no longer renew loans. At that moment existing loans became financial anchors and for many borrowers the source of foreclosure.
How The 30-Year Fixed-Rate Mortgage Started
With the advent of the FHA mortgage guarantee program in the 1930s something new was popularized — the self-amortizing, fixed-rate, long-term mortgage, a loan which lasted 20 years. With such financing there was no longer a need to renew the mortgage every few years because at the end of the loan term there’s no debt. If the value of the property goes up or down it doesn’t matter as long as the borrower continues to make monthly payments.
By 1948 the FHA was offering 30-year fixed-rate loans and today the 30-year fixed-rate mortgage (FRM) dominates the market. The catch is that such loans are only three decades in length and fixed for borrowers. For investors the story is different:
“The primary difference between the U.S. 30-year fixed-rate mortgage and shorter-duration loans is who bears the interest rate risk,” says the liberal Center for American Progress. “For the 30-year mortgage, the interest rate risk is borne by financial institutions or investors in mortgage-backed securities. Borrowers of the 30-year fixed-rate mortgage have cost certainty for the duration of the loan, which shields them against any sudden increases in their loan payments.
“But for shorter-duration mortgages, interest rate risk is largely transferred to the borrower, who now has cost certainty for only a short period of time — until the loan rolls over or the “teaser rate” expires — after which he may face a payment shock if interest rates have risen significantly. Financial institutions and investors bear far less interest risk in this product.”
The conservative Heritage Foundation largely agrees.
“Lenders take on the risk that borrowers will make all of the scheduled payments for the life of a loan,” says the Foundation. “The longer the term of the loan, the more risk that the loan will not be paid back. Another type of mortgage risk, referred to as “interest-rate risk,” is that the value of a mortgage falls when interest rates rise. For example, if a bank lends money at 4 percent interest on a 30-year FRM, it loses money when interest rates rise because it cannot earn the higher rate. On the other hand, FRM lenders are in a better position when rates fall because their existing loans pay a higher rate than any new loans would earn.
“While these scenarios may appear to balance out — a rise in rates favors the fixed-term borrower while a fall in rates benefits the fixed-term lender — a key feature of the U.S. market pushes virtually all FRM interest-rate risk onto the lender. When interest rates fall, borrowers are virtually unrestricted from refinancing their loan by securing a new loan at a lower rate and paying off the old loan. Many state laws prohibit banks from charging borrowers fees (prepayment penalties) when they pay off a loan ahead of schedule. Furthermore, after 1979, Fannie Mae would only purchase FRMs ‘without’ prepayment penalties.” (parenthesis theirs)
Lenders and investors are not going to see the widespread use of prepayment penalties anytime soon — they’re banned with FHA, VA and conventional loans and restricted under the “qualified mortgage” (QM) requirements established by Dodd-Frank.
Also, another “key feature” of 30-year mortgages — one which somehow is not frequently mentioned — they rarely last 30 years or anything close. According to Freddie Mac the typical loan survives just 5.6 years before being paid off or refinanced.
Why not dump FRMs altogether?
The 30-year FRM is simply the accepted baseline form of financing that just-about everyone wants. According to EllieMae, in April only 10.3 percent of all closed loans were 15-year mortgages and just 4.5 percent were ARMs. The rest — the overwhelming majority, were 30-year, fixed-rate mortgages.
What’s surprising about these numbers is that lenders make substantial concessions to market ARMs. For instance, at this writing a 30-year FRM has a 3.87 percent rate while a five-year ARM has a 2.96 percent start rate and more liberal qualification standards. For most borrowers, the ARM is arguably the better loan choice since most real estate loans are likely to last less than six years and yet most borrowers do not take the bait, no doubt because they fear future rate hikes.
Higher Mortgage Rates Ahead
Nick Timiraos of The Wall Street Journal says the 30-year fixed-rate loan is “not unheard of in the rest the world but it’s rare” and describes it as a “Frankenstein product.”
The sure and certain way to end most 30-year financing is to get rid of Fannie Mae and Freddie Mac, the government-controlled entities which buy, guarantee and package such loans for investors. Indeed, there have been at least 25 proposals on Capitol Hill to dump Fannie Mae and Freddie Mac and replace them with something new and different.
These replacement proposals all have two central features:
First, somewhere in the mix there’s a government guarantee, backing generally described as small and financially unimportant without mentioning that Fannie Mae and Freddie Mac each had just a $2.5 billion line of credit with the U.S. Treasury before the mortgage meltdown and yet together received $187 billion in bailout money.
Second, there’s not much talk regarding what happens to rates if the 30-year mortgage option largely ends.
According to Approved Mortgage in Orange City, FL, “eliminating Fannie and Freddie would mean that conventional loans, like the 30-year mortgage, would no longer be guaranteed. What that means for consumers is that long-term, fixed-rate loans would become too expensive to be an option. And with traditional, fixed-rate mortgages comprising the majority of the market, a loss of guarantee could be disastrous.”
In “Way Too Big To Fail,” a book by mortgage authority William A. Frey, he writes that without Fannie Mae and Freddie Mac borrowers could see an additional 1 percent added to the annual interest rate of every new mortgage. That’s roughly a 25 percent increase given today’s 4 percent rates.
Mark Zandi, the chief economist at Moody’s Analytics, takes a more conservative view and says without Fannie Mae and Freddie Mac the cost of a $200,000 mortgage could rise by $75 to $135 per month — that’s an increase of about .45 percent to .81 percent on top of today’s rates.
And this brings us to a basic concern: Even with interest rates not far from historic lows home sales are hardly robust. In fact, in 2014 existing home sales were actually 3.1 percent lower than the year before. What would happen to the housing market and the economy in general if mortgage rates rose with the elimination of the 30-year fixed-rate mortgage?
Until this question is answered the FRM is likely to continue as the financing option favored by most borrowers for years to come.