We usually think of 30-year mortgages as the basic pillars of real estate finance but do we really need fixed-rate loans that last three decades?
The truth is that most loans never make it 30 years or even come close. Mike Fratantoni, chief economist with the Mortgage Bankers Association tells RealtyTrac that it’s tough to figure out the average time a loan is outstanding because the number is a moving target. “During refi booms,” he says, “it becomes very short. As rates rise, it gets very long. It is difficult to predict just how long the average life will be. On average, people move every seven years, but that is made up of young people who move a lot and older people who don’t.”
Writing for the conservative Heritage Foundation, John L. Ligon and Norbert Michel argue that 30-year fixed-rate mortgages (FRMs) are unattractive to borrowers for several reasons:
- Interest rates for 30-year FRMs are higher than the rate for loans with shorter terms, such as 15-year financing.
- Interest costs for 30-year FRMs are higher than the costs paid by borrowers with shorter-term loans.
- Equity grows slower with 30-year FRMs then with loans that have shorter terms.
These points are all factually correct but for most borrowers the greater issue is this: The monthly cost of a 30-year mortgage is cheaper — a lot cheaper — than financing with a shorter term. For example, borrow $300,000 at 4.25 percent and the monthly cost for principal and interest will be $1,476. Borrow the same amount at the same rate for 15 years and the monthly payment will soar to $2,257.
Fifteen-year loans are available today but like old vegetables sitting lonely and sad on the grocer’s shelf few people want them. According to Ellie Mae, 15-year mortgages accounted for just 9.7 percent of all the mortgages originated in May. The reason is that with a higher monthly payment relatively-few prospective borrowers qualify for such financing. Here’s why:
Imagine that the borrower in need of a $300,000 mortgage will pay $500 a month in property taxes and $150 a month for property insurance, a total of $650. If we allow 43 percent of the borrower’s income to be used for housing costs including principal, interest, taxes and insurance — and if we assume the borrower has no other debt such as student loans, car payments or credit cards — the borrower looking for 30-year financing will need a monthly income of $4,944 to qualify versus $6,760 for the borrower who wants 15-year financing.
In practice, the interest rates for 15-year financing are lower than the interest levels for longer-term loans but the idea is constant: The monthly costs for shorter, self-amortizing loans are higher than for mortgage products with a long term.
Interest Rate Risk
On the other side of the transaction, Ligon and Michel argue that 30-year financing is inherently problematic for lenders — and then undercut their own argument.
“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.”
The real interest rate risk for lenders is that making loans is unattractive when rates are low, as they are today. Because there’s little chance that rates will fall much further the opportunity to earn more than current rates is small.
Four Hard-Time Hedges For Borrowers
Borrowers like 30-year FRMs precisely because such financing allows them to lock-in financing costs for the long term. Such loans are a hedge against inflation and — equally important — 30-year FRMs are also a hedge against hard times.
First, with a 30-year mortgage if you lose your job you don’t have to lose your home. Just pay your mortgage from savings or with help from friends and family until you get back on your feet. Alternatively, if you have a loan with a shorter-term, say five years, then all bets are off. You might not qualify for refinancing if your income has declined and if you can’t refinance then foreclosure can loom ahead.
Second, long-term loans are also a hedge against equity declines. Imagine if you have a loan with a five-year term, your income is fine, but the value of your home has fallen. To refinance you now need to bring extra cash to closing, perhaps tens of thousands of dollars. If this seems unlikely consider that in April home prices nationwide remained 6.9 percent lower than the 2007 peak, according to the Federal Housing Finance Agency.
Third, borrowers also prefer fixed-rate financing because there is no possibility of “payment shock” the instant onset of higher rates that can take place with some forms of ARM mortgages.
Fourth and lastly, 30-year FRMs are a hedge against refinancing costs. If you have to get a new loan every five or ten years you also have to pay for it. The result is a need for new closings and big costs for title searches, recordation taxes and closing fees.
A New Breed of ARMs?
The obvious alternative to 30-year FRMs is the adjustable-rate mortgage. They’re here, they’re available with lower start rates than fixed-rate financing, but they’re less fashionable then 15-year loans: Ellie Mae says that in May ARMs represented just 7.6 percent of all loan originations, making them about as popular as Congress in the latest Gallup poll.
A New Loan Idea: The 15/15 ARM
In thinking about future financing options it may well be that a newly-emerging ARM product could satisfy a lot of borrowers and lenders: A 15/15 ARM is now being offered, in many cases by credit unions.
The attraction of a 15/15 ARM is that it has some balance. Borrowers get a lower start rate but are unlikely to ever face a rate hike because most will probably move or refinance long-before 15 years. Lenders are not tied to a single rate for 30 years, giving them a modest hedge against inflation.
As an example, a 15/15 ARM is available today at 3.5 percent with 0 points. After 15 years the rate will adjust, up or down. If it goes up the maximum rate increase is 6 percent, meaning the rate could go to as much as 9.5 percent. In contrast rates today for a fixed-rate loan are roughly 4.25 percent.
How does a 15/15 ARM compare to the fixed-rate loan? Let’s imagine that $200,000 is borrowed. The initial principal-and-interest payment for the fixed-rate loan is $984 a month versus $898 for the 15/15 product.
The big question, of course, is what happens after 15 years? We know that the fixed-rate loan chugs along at $984 but what about the 15/15 ARM?
After 15 years the loan balance for the 15/15 loan product has been reduced to $125,096 versus $130,266 for the fixed-rate loan. The 15/15 ARM now adjusts. In the worst case the interest rate rises to as much as 9.5 percent (the 3.5 percent start rate plus 6 percent). The monthly principal-and-interest cost for a $125,096 debt with a 15-year term is $1,306.
For the borrower the better idea in this scenario is to take the 15/15 ARM and make monthly payments as if the interest rate is 4.25 percent. In other words, prepay the mortgage. With monthly payments of $984 per month after 15 years the 15/15 ARM with a 3.5 percent interest rate will have a remaining balance of $105,328. If the rate goes to 9.5 percent after 15 years the new payment will be $1,100.
Will the higher payment be a burden? Probably not. With 2 percent inflation $984 in today’s dollars will have the same buying power in fifteen years as $1,324, according to buyupside.com.
Of course, the example presented here shows the worst situation, a full 6 percent interest increase. It’s more likely that the borrower will never face an interest escalation because the loan will be retired through the sale of the property long-before 15 years is up. It’s entirely possible that rates will increase less than 6 percent and there’s even some chance that future rates might fall. After all, 15 years ago the typical mortgage rate for 30-year financing was 7.55 percent, according to Freddie Mac.
Dumping 30-year fixed-rate loans would substantially increase market-place risk and lower origination volume. That’s a bad mixture for both borrowers and lenders, a combination which is surely not going to happen in a marketplace which remains both troubled and fragile.