The Cost of Surrendering the 30-Year Fixed Rate Mortgage Loan

The 30-year fixed rate loan is an aberration that exists primarily because of government support.
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The New York Times ran a story earlier this week suggesting that if Fannie Mae and Freddie Mac cease to exist, the 30-year fixed-rate residential mortgage loan would become a "luxury" product rather than the norm. This kind of shift could have profound economic consequences that policymakers need to carefully consider.

As the story noted, the 30-year fixed rate loan is an aberration that exists primarily because of government support. There are three key characteristics of the now-typical loan that merit discussion: (1) its long-term nature; (2) the fixed interest rate; and (3) the full amortization.

(1) Thirty years is a long-term loan. In contrast, commercial mortgage loans have terms between three and ten years. As a result, commercial borrowers are forced to refinance on a more frequent basis than residential borrowers. With a longer-term loan, homeowners are currently freed from refinancing risk (what if no lender is willing to lend money secured by my house), interest rate risk (what if interest rates have gone up since I last refinanced), and closing costs associated with each new loan.

(2) The typical prime residential mortgage is at a fixed interest rate. This mitigates a major risk for the borrower - that interest rates will rise and make payments unaffordable. Conversely, lenders don't like fixed-interest rate loans because it forces them to internalize the interest rate risk, which they must mitigate with other financial products. Without government intervention, lenders have significant incentives to switch to floating rate mortgage loans, which shifts the interest rate risk back to borrowers.

(3) Finally, the normal residential mortgage is a fully amortizing loan, which means that at the conclusion of the 30-year term, the principal is paid in full. Fully amortizing a loan over a long term further reduces the borrower's refinancing risk. If the borrower likes her home and can afford her mortgage, she need never refinance. She can stay in her home, making payments for 30 years and, at the conclusion of the term, have a bonfire in the backyard to burn the mortgage. In contrast, shorter-term commercial loans are partially amortizing, which means that they amortize over 20 or 30 years but must be repaid in three to ten years. As a result, when the borrower is forced to refinance, a large lump sum payment of principal is due.

Because of their 30-year mortgage loans, residential borrowers have actually been advantaged over commercial borrowers during the current economic downturn (although it obviously doesn't feel that way.) CoreLogic reported yesterday that nearly 1 in 4 American homeowners are "underwater" on their mortgages, meaning that they owe more than their homes are worth. Collectively, this results in an "equity gap" of approximately $751 billion. While these underwater borrowers understandably feel stress, if they are current on their payments and don't have to move, they will not be forced to internalize the current discounted value of their homes. Because of the long-term nature of their loans, they can wait out the economic downturn and sell or refinance when home values rebound.

Commercial borrowers face a more pressing problem. The "equity gap" for commercial real estate borrowers has been estimated at over $1 trillion. But given the short term nature of their loans, many commercial borrowers with maturing loans have been forced to: (1) sell into a distressed market; (2) surrender their properties to the lender through foreclosure or deed in lieu of foreclosure; or (3) refinance by contributing additional equity (i.e. an increased downpayment). If the standard residential mortgage term is reduced from 30 years to 10 years, in the next economic downturn, underwater homeowners who are current on mortgage payments but facing a maturing loan will face increased uncertainty.

So, to summarize, a shift away from a standard 30-year fixed interest rate loan could have profound economic consequences. If the new standard is, say, a 10-year, floating rate, partially amortizing loan (which more closely resembles the commercial real estate product), then homeowners face increased costs, refinancing risk, interest rate risk, and "equity gap" risk in the event of falling home prices. None of these are risks that American homeowners have confronted in generations. If homeowners are rational, they will minimize their risks by decreasing their expenditures on housing. As a result, fewer Americans may own homes, and those that do may downsize to less expensive homes. While neither of these outcomes may be a bad thing, it isn't the best idea to force these radical behavioral changes in the middle of an economic recession, with a distressed housing market, and an oversupply of single-family housing stock.

The American residential real estate financing system is in need of real reform. But policymakers need to carefully consider the economic consequences of the changes that they are suggesting.

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