April 10, 2017

Why America's Homebuyers & Communities Rely on the 30-Year Fixed-Rate Mortgage

Sean Becketti
Sean Becketti, VP Chief Economist*

Remember in 2013 when the 15-year fixed-rate mortgage was an unbelievable bargain at just over 2.5 percent, the lowest in recorded history and about three-quarters of a percentage point below a 30-year fixed-rate loan? So everyone buying a house was getting a 15-year loan, right?

Nope. Thirty-year fixed-rate mortgages dominated, accounting for almost 90 percent of the home-purchase loan market.

Fast forward to today—the 30-year fully amortizing fixed-rate mortgage is averaging just above 4 percent through March and is still by far the most popular mortgage product for America's homebuyers. In fact, about 90 percent of homebuyers chose the 30-year fixed-rate mortgage in 2016. Six percent of homebuyers chose 15-year fixed-rate loans, 2 percent chose adjustable-rate mortgages (ARMs), and 2 percent chose loans with other terms.

Three advantages of 30-year, fixed-rate mortgages account for their overwhelming appeal to homebuyers.

Affordable: First, the longer term means the principal is paid back (that is, "amortized') over a longer time period. That means the monthly payments are lower than on a 15-year fixed-rate mortgage, which is fundamental to making homeownership viable for first-time buyers in their early earning years. Just like the Baby Boomers did, Millennials will rely heavily on the 30-year fixed-rate mortgage because the lower payments are more affordable and manageable when getting started. And with wage gains just now starting to make a comeback after being depressed for years, there's a lot of ground to make up to catch house prices that have been rapidly rising. In fact, low down payment mortgages such as the Home Possible mortgage make it possible for prospective homebuyers to put down as little as 3 percent to obtain a 30-year fixed-rate mortgage versus continuing to pay high rents.

Stable: Because the interest rate is fixed, the monthly principal and interest (P&I) payment is constant over the 30 years of the loan, insulating borrowers from payment shock. In contrast, an ARM with a 30-year term will have variable P&I payments over the loan term. Many moderate- and middle-income homeowners prefer the certainty that comes with fixed P&I payments and are often ill-suited to manage the interest-rate risk that comes with an ARM. For example, those who took out ARMs during the peak years of the boom (2005-2007) saw their P&I payments soar by as much as 165 percent – that's an enormous increase and financial burden. Moreover, by avoiding payment shock, fixed-rate borrowers are less likely to fall behind on their payments – a plus for investors, too.

Stability also is good for communities. In the housing market bust in the U.S., those states that had relatively high percentages of long-term fixed-rate lending to prime-credit borrowers generally fared much better than the states that had much smaller shares of the product.

Flexible: Thirty-year fixed-rate loans are generally prepayable at any time without penalty. If the homeowner chooses to pay off the loan before maturity to refinance or sell the home, the homeowner can do so without paying an early prepayment fee. This feature is largely unique to the U.S. as other nations generally sport a prepayment penalty for long-term fixed-rate loans on single-family homes.

Bottom line:  While we take the 30-year fixed-rate mortgage for granted, it's actually a newcomer. Prior to the Great Depression of the 1930s, mortgage terms extended to only five or ten years, at which point the mortgage had to be refinanced or paid off. And forget about fixed rates and level payments—most mortgages carried adjustable rates. In addition, borrowers typically could borrow no more than 50 percent of the value of the house. Imagine the reaction if 50 percent down payments were required today.

How did we get from the short-term, adjustable rate mortgages of the past to the 30-year fixed rate mortgages of the present? Well, you can't give the credit to market forces or the entrepreneurial vision of financiers. The 30-year fixed rate mortgage owes its existence to government actions to remedy dislocations in the mortgage market. The process started during the Great Depression, when the federal government created the Home Owner's Loan Corporation (HOLC) to buy defaulted mortgages and reinstate them. HOLC transformed the original short-term, variable rate mortgages to more-affordable 20-year fixed-rate mortgages, the first step to what eventually became the fully-amortizing, 30-year fixed-rate mortgage that dominates mortgage lending today.

The considerable benefits of the 30-year fixed rate mortgage to consumers are beyond question. However, this type of mortgage isn't a natural fit for lenders. All the features that benefit the consumer—long term, fixed interest rate, and the option to prepay the loan without penalty—create serious headaches for lenders. As a result, the federal government created Freddie Mac and other institutions that allow lenders to hand these headaches over to the capital markets, where sophisticated portfolio managers have the tools and expertise to manage the investment risks of the 30-year mortgage. Freddie Mac and its sister institutions make possible a steady, reliable flow of funds from capital markets to individual homebuyers even in periods of economic upheaval. And they make possible the low and stable payments and flexibility of the 30-year fixed rate mortgage.