The conventional wisdom holds that a housing finance system built on the bedrock of long-term, fixed-rate mortgages—the sensible, historic, ostensibly free-market way to buy a home—is the key underpinning of the country’s residential real estate market and the economy as a whole. A closer look, however, shows that fixed-rate mortgages aren’t innately secure and that their ubiquity results from government programs that cost a lot but do little to increase home ownership. Indeed, today’s economy may require policies that demote or even end the reign of the conventional fixed-rate mortgage.
A typical mortgage in the United States comes with a fixed interest rate, a “self-amortizing” payment schedule of 15 or 30 years of fixed monthly installments, and no prepayment penalties, so borrowers can refinance whenever they please. These features have obvious attractions to consumers because they assure that monthly housing payments will go down in real terms: Over the last 30 years, inflation alone would have reduced the actual value of a mortgage payment more than 60 percent. And, of course, since prepayment penalties are rare—Fannie Mae and Freddie Mac, which buy all but the biggest mortgages, won’t enforce them on most loans—anyone who finds a better deal can refinance simply by paying closing costs. As a result, about 90 percent of mortgages in the United States are offered on a fixed-rate basis and very few have prepayment penalties.
Nice as all this is for borrowers, it places lenders in a no-win situation that wouldn’t exist without these government assurances. Banks profit by borrowing money for the short term and lending money for the long term. When long-term interest rates go down, bankers see huge numbers of their best borrowers refinance at a lower rate. On the other hand, if short-term rates go up, lenders need to pay higher rates on deposits and bonds while collecting revenue from mortgages financed at lower rates. The latter state of affairs, indeed, played a role in rendering more than one in six of the country’s savings and loans insolvent in the 1980s. These policies lock the entire housing economy into a boom and bust cycle.
Put simply, banks would not be offering fixed-rate mortgages without prepayment penalties were it not for the numerous interlocking taxpayer guarantees that come with such mortgages. Indeed, in only one other country, Denmark, do banks offer consumers anything like the mortgages in the United States—and even there, stiff down-payment requirements make such loans far less popular than they are in this country.
In fact, stripping away the façade of private banks and mortgage brokers who originate the loans, the U.S. mortgage market works almost entirely because the government transfers risk to the taxpayer in order to let banks market a product that no sane financier would ever sell in the free market. A study by economist Michael Lea, a professor at San Diego State University, concludes that no other sizable developed country intervenes as pervasively in its mortgage market as does the United States.
The primacy of the 30-year fixed-rate mortgage makes the promises by members of Congress to rein in Fannie Mae, Freddie Mac, and various other bad housing actors impossible to keep. In fact, several provisions of the Dodd-Frank bill that congressional Democrats and the Obama administration developed in response to the financial crisis reinforce the 30-year fixed-rate mortgage by offering lenders safe harbor for retaining its current features.
Even House Republicans, willing to play with political fire by calling for an end to the current Medicare system for those under 55, haven’t passed any major legislation to curb Fannie and Freddie largely because they can’t figure out a way to do so without simultaneously making it impossible to get 30-year mortgages on anything like the current favorable terms. And they’re right to be discouraged about this prospect: Any policy that keeps mortgage terms like the current ones in force will require taxpayers to take on the risks, since the very product wouldn’t exist in a free market.
That said, eliminating the 30-year mortgage wouldn’t be a bad idea. For starters, there’s very little evidence that this form of financing is required for current rates of homeownership. Mediterranean economic basket-cases Spain and Greece both have homeownership rates higher than the United States, despite being some of the poorest developed countries and offering mortgage terms in some respects less generous than those typically found stateside. Canada and the United Kingdom, two places more culturally (and economically) similar to the United States, have about the same homeownership rates even though mortgages there typically come with prepayment penalties and have variable interest rates.
The logical conclusion is that factors related to culture and geography, not mortgage finance, determine homeownership rates. And, even if homeownership did decline without 30-year mortgages, that wouldn’t be a disaster: A 40 percent homeownership rate has not turned Switzerland into a basket case, and a 74 percent rate in Alabama hasn’t made that state’s economy the envy of the world. In fact, high homeownership rates in places like Ohio and Michigan have exacerbated those states’ woes, by trapping unemployed workers in “upside-down” houses that they can’t sell for a price high enough to pay off the mortgage and seek jobs elsewhere.
Likewise, an increase in the use of adjustable-rate mortgages didn’t contribute to the financial crisis and might have ameliorated its impact. While it is true that adjustable-rate mortgages had higher default rates than fixed-rate ones, this happened largely because the most gimmicky products of the last decade, such as the infamous “no doc/low doc” loans with zero down payments, happened to be combined with adjustable-rate mortgages.
Australia and Canada, where foreclosures have barely increased during the recent morass, have many more adjustable-rate mortgages than the United States. In fact, some economists have identified such loans as a source of macroeconomic stability, because they help banks keep their heads above water in bad economies. The countries with big foreclosure surges—the United States, Spain, and Great Britain—were all places where gimmicky mortgages became far more common than regulators should have allowed.
Furthermore, many of the supposedly consumer-friendly features of today’s mortgages aren’t as “friendly” as they appear. Were prepayment penalties more widespread, interest rates would fall by about half a percentage point, economists estimate. And with Fannie Mae and Freddie Mac stripped of any implicit promise of a government guarantee, other enterprises could enter the mortgage securitization business, likely figuring out less risky ways to do it—or at least more efficient ways.
Americans’ financial lives have changed in myriad ways in the last several decades: The types of deposit accounts, savings instruments, consumer credit products, and investments that middle-class Americans purchase today are vastly different from those among which their parents chose. But mortgages, for the most part, haven’t changed at all. Changing them now—and implementing policies that do away with the implicit guarantees behind the 30-year mortgage—could cut back a hugely expensive bureaucracy and stabilize the financial system, and with little consequence for homeownership rates. Congress shouldn’t be afraid of killing the 30-year mortgage.
Eli Lehrer is vice president of the Heartland Institute. Ike Brannon is director of economic policy at the American Action Forum.