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Long-term, Fixed-rate Mortgages: An American Economic Shock Absorber

Deputy Chief Economist Amy Crews Cutts The long-term fixed-rate mortgage has emerged as an economic shock absorber for millions of households and thousands of neighborhoods during the current downturn. Specifically, 30-, 20- and 15-year fixed-rate mortgages are delivering three vital benefits to borrowers, investors, and communities.

Borrowers – No Mortgage Payment Shock. Let's start with the obvious. Between 2005 and 2007 – the peak years of the housing boom – borrowers who took out different types of adjustable-rate mortgages (ARMs) saw their principal and interest (P&I) payments soar by as much as 165 percent a few years later. What's more, many borrowers with option pay ARMs also saw their home equity erode, which exacerbated the collapse in home values. (Option pay ARMs let borrowers make minimal mortgage payments and add any unpaid interest to the balance of their loan, i.e. negative amortization.)

By contrast, borrowers who took out long-term fixed-rate loans had predictable and stable P&I payments that insulated them from mortgage-driven payment shock. Given the uncertainty of income brought on by the recession, this stability was a home-saving feature for many.

Investors – Lower Delinquency Rates. By avoiding payment shock and negative amortization, borrowers with long-term fixed-rate mortgages have been less likely to fall behind on their mortgage payments.

Subprime and ARMs Have the Highest Serious Delinquency Rates
Percent of Loans Seriously Delinquent 

In fact, by the fourth quarter of 2009, serious delinquency rates on subprime adjustable-rate loans had risen to over 42 percent and prime adjustable-rate loans had a serious delinquency rate of over 18 percent according to the Mortgage Bankers Association of America's (MBA's) National Delinquency Survey. By contrast the overall fixed-rate mortgage delinquency rate as reported by the MBA stood at 8.1 percent and Freddie Mac's fixed-rate delinquency rate was only 3.5 percent. (Seriously delinquent loans are 90 days or more delinquent or in the legal foreclosure process. 1)

What's more, at the start of this year, prime adjustable-rate and subprime mortgages accounted for 21 percent of the nation's outstanding home loans but accounted for 47 percent of all foreclosures started over the first half of the year, according to the MBA's delinquency survey. By contrast, prime fixed-rate mortgages accounted for 64 percent of the nation's outstanding mortgages and 38 percent of foreclosures started.

The reason for the disparity is not a mystery and has been well reported in the press. In the wake of the subprime market implosion, many ARM borrowers were unable to refinance their mortgages and avoid punishing interest-rate resets as private investors pulled their capital out of the market and lenders tightened underwriting standards and borrower documentation requirements. Borrowers with fixed-rate mortgages were under no such pressure to refinance.

(It's worth noting at this point that as of December, 31, 2009, 91 percent of Freddie Mac's portfolio was composed of conforming, conventional fixed-rate mortgages, and this delinquency rate, which is historically high, is due to the collateral damage from the broader downturn – rising unemployment, declining incomes, and falling home prices – that has adversely affected all types of mortgages.)

Communities – Greater Home Price Stability. During the current housing crisis, home prices fell the least in markets where the most borrowers took out fixed-rate mortgages like those financed by Freddie Mac or Fannie Mae, or insured by the Federal Housing Administration or guaranteed by the Veterans Administration.

Home Prices Fell Most Where Borrowers Passed on Fixed Prime Loans
HPI 1995-2010 

In states where adjustable or exotic mortgage products were the most prevalent, home values fell on average 39 percent or more from their recent peak in 2006 or 2007 according to the Federal Housing Finance Agency's House Price Index. 2 

Now look at this. (To see HPI vs. Fixed Rate Mortgage for all 50 states, click here.) The states where home prices fell the most – Nevada (- 52 percent), California (- 42 percent), and Florida (- 40 percent) – were also the states where relatively few borrowers had prime fixed-rate, FHA or VA long-term fixed-rate mortgages. Only 51 percent of the loans in Nevada, 52 percent in California and 54 percent in Florida were long-term fixed-rate mortgages.

But home prices are down less than five percent in states where prime, FHA or VA long-term fixed-rate mortgages are predominant. In fact, home prices have slipped two percent or less in the states with the highest percentages of these mortgages – South Dakota (85 percent), North Dakota (84 percent), and Texas (70 percent).

The bottom line: when private capital for home loans disappeared in the wake of the Great Depression in the 1930s, Congress stepped in and enabled FHA to create a viable long-term fixed-rate mortgage product. This brought private capital back into mortgage financing and reinvigorated the housing market. Since then the fixed-rate mortgage has evolved into its current 30-year, fixed-rate freely prepayable form that is the dominant choice among America's homeowners.

And it is in this form that the long-term fixed-rate mortgage is working as an economic shock absorber, insulating families from payment shocks, protecting mortgage investors from the highest delinquency rates, and providing a welcome measure of stability to America's home prices and communities.

1 According to the MBA, the prime and subprime criteria used in the National Delinquency Survey are based on survey participants' reporting of what they consider to be their prime or subprime servicing portfolio. Alt-A loans are accounted for within the statistics for prime and subprime loans.

2 Home-price changes measured using the Federal Housing Finance Agency's Purchase-transactions HPI Series. Prevalence of fixed-rate vs. other mortgage products determined by share of loans that was prime fixed-rate or insured by the FHA or VA as reported in the MBA's National Delinquency Survey. Prime fixed-rate share as of Q1 2006.

*Amy Crews Cutts left her position as Deputy Chief Economist of Freddie Mac in March 2011.


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