Reflecting on the 30-year Fixed Rate Mortgage

The sharp rise in mortgage rates from May to July of this year presents an opportunity to reflect on the merits of one pillar of the US mortgage finance system; the 30-year fixed rate mortgage. The 30-year FRM has many positive and a few negative qualities, but its role in the U.S. system is central and provides consumers with multiple important benefits. Additional options and alternatives for a stable long-term financing product could only benefit the system, but it is important to maintain one that works.

Rates for the 30-year FRM fell steadily over the last 30 years, but that trend is likely now at an end. Economic growth and the imminent end of the Fed’s MBS and Treasury purchase programs will likely cause long-term borrowing rates to rise over the next decade. This trend will present both lenders and consumers with challenges. Lenders will need to balance the risks of rising interest rates on deposits against fixed returns on portfolios of long-term mortgages. Likewise, mortgage backed securities with low coupons, or the rate paid to investors who own them, will fall in value as mortgage rates rise, creating headwinds for that funding channel. Consumers on the other hand will need to modify expectations for affordability and purchasing power as rising rates and inflation will erode both unless income growth can rise enough to compensate.

One alternative to a 30-year fixed rate mortgage is an adjustable rate mortgage, which can provide low upfront payments. Consumers can refinance these mortgages after a fixed term. This solution helps banks as it limits their exposure to a term miss-match between the short-term deposits that they fund longer term loans with. Consumers benefit from the lower upfront payment, but they face payments that are likely to increase when the rate resets or is refinanced. This change would reduce affordability and make it more difficult for consumers to budget for long-term priorities like saving for a child’s education or retirement. For example, if a consumer were to mortgage a property for $180,000 today with a 30-year FRM and a rate of 3.9%, the monthly principle and interest payment would be $845. The payment for the same home financed with a 5/1 ARM at 2.8% would be $744. However, in five years the payment on the ARM resets to float with the forecasted market rate [1] of 6.7% but limited by maximum 2% annual increases under the qualified mortgage rule. Thus, the monthly payment would increase by $205 to $949 in the 6th year before rising again by $213 in year seven for a total increase of 52% over the introductory fixed period. The ARM payment would be $285 higher than the fixed rate payment and it could rise further depending on market conditions. Furthermore, a borrower who held the fixed mortgage for eight years would benefit more than if they had held the 5/1 ARM and invested the proceeds of lower initial monthly payments. That benefit would reach $5,180 after a total tenure of nine years. One might refinance an ARM, but there too costs are incurred and access to a refinance might not be available if you are under water, standards are raised, or if finance markets are unstable. A borrower who is confident and correct in anticipating a shorter ownership period might benefit from a five or seven year ARM. Otherwise an ARM presents uncertainty and costs to a risk averse consumer.

Another option would be to finance the purchase with a 15-year fixed rate mortgage. This option helps originators again as the shorter term is easier to manage. However, for a consumer financing the purchase [2] the principle, interest, taxes and insurance using the 15-year product is $365 or 32% greater than with a 30-year mortgage. [3] What’s more the higher payment would cause the purchaser’s debt-to-income payment [4] to jump from 26% to 35%, a figure that might not pass underwriting, or might require a higher mortgage rate to compensate. To achieve the same DTI, the consumer would need to reduce the purchase price by nearly a third, a difficult proposition given relatively inelastic or fixed consumer expectations and market pricing of home size, commute and school districts.

But do consumers value the stability of a 30-year fixed rate mortgage? Based on the realized market share of the 30-year fixed in the conventional market since 1990, one can see that the 30-year FRM has enjoyed a significant if not dominant market share, a reflection of consumers voting with their wallets. This dominance was persistent through periods of both rising and falling mortgage rates.

An ARM might be a good product for a consumer who can accurately forecast mortgage rates, how long they’ll live in a house, who is comfortable with multiple refinances and who has access to credit regardless of market conditions. Other buyers may not be as perceptive, confident, or they might have another reason for preferring the longer duration of a 30-year fixed rate mortgage. Historically the average tenure for a home before resale was 6 years. That figure increased to 9 in recent years due to turmoil in the housing market and the recession. Tenures may ease in the near term with resurgent home values allowing many pent up sellers to come to the market along with a return to historically safe lending standards, but rising mortgage rates, weak income growth, more moderate price gains, and tighter credit standards are likely to extend household tenures for most owners in the long-term.

More important is the fact that tenure varies over the life cycle. Younger buyers may own a home for a few years before trading up, but by mid-life that pattern slows and the share of buyers who hold for longer than 15 years increases significantly, likely a reflection of the need for stability in child rearing. For instance, 21% of home sellers ages 45 to 54 years sold after 15 years, which means that they bought when they were 30 to 39. This pattern increases dramatically in the years after age 55, a period in which budgeting and increased savings is critical for retirement. This trend is likely to grow as the share of homeowners with defined benefit retirement programs decline and as the benefits from social security and Medicare decline.

Recently, the merits of the 30-year fixed rate mortgage have been debated in some mortgage finance circles. However, there appears to be little dispute for consumers; the 30-year FRM is a valuable tool for budgeting and that value will only rise with mortgage rates over the coming decade.

[1] Estimated as the CBO’s February baseline forecast of the 3-month Treasury plus the average margin from the PMMS survey. The 3-month Treasury is the only long-term forecast available and would be slightly lower than the LIBOR or prime rate. As such, this estimate is conservative and would likely be higher.
[2] Assuming a 10% down payment or a $200,000 home price, nearly the $208,000 March median national existing home price
[3] June average 30-year FRM and 15-year FRM rates from FHLMC
[4] Median household income from BLS forecasted through 2013