Is the 30-Year Fixed Rate Mortgage Causing Issues with the U.S. Housing Market?
BY Graham Steele-Perkins
If you have been paying any attention to the news over the past few years, you have likely heard that it is a difficult time to buy a home. Following a period of frenzied activity during the pandemic, the housing market has since sunk into a “deep freeze”. Skyrocketing prices, limited inventory, high mortgage rates, and stiff competition have all contributed to the nightmare that is the current U.S. housing market. However, one overlooked factor that may be contributing to this problem is the uniquely-American financial instrument known as the “30-year fixed rate mortgage” (“30-year FRM”).
The 30-year FRM evolved out of the Federal Government’s efforts to combat the Great Depression. It provides homeowners the ability to finance the purchase of a home with a low (20%) down payment, by paying the remaining balance in installments over a period of 30 years. Critically, the interest rate on this loan remains the same for the lifetime of the mortgage. The 30-year FRM has been traditionally thought to be an extremely homeowner-friendly policy, because the homeowner is protected from rises in interest rates, and has the ability to refinance or prepay the loan with no penalty.
The flip side of this is that 30-year FRMs expose banks and other lenders to higher amounts of risk. Banks must be extremely cautious when making lending decisions because they will be unable to raise the interest rate.
Some commentators have posited that the 30-year FRM has created a “lock in” phenomenon in the current housing market. Potential sellers are unwilling to put their homes on the market, because they will be unable to obtain an interest rate comparable to their current one. This has depressed the housing inventory available, leading to an increase in prices and a reduction in transactions. Current mortgage interest rates are in the 7% range. So even if a seller wanted to downsize to a smaller and less expensive home, they could potentially end up with a similar monthly payment because they would be paying more in interest every month.
Mortgage instruments in the rest of the world look different than in the U.S. Much of the rest of the world utilizes adjustable rate mortgages (ARMs). These mortgages typically have an initial term where the interest rate is fixed, after which the rate shifts to the prevailing market rate. Denmark, however, has a system that is similar to the U.S., but with a twist.
Most mortgages in Denmark, like in the U.S. are long-term fixed-rate. Unlike the U.S., however, the Danish mortgage system operates under the “Balance of Principal” concept. What this means, essentially, is that mortgages are financed through the issuance of “covered bonds” through specialized mortgage banks. The covered bonds match the maturity and cash flows of the underlying pool of mortgages funded by the bond. Cash flows pass directly from the borrowers to the bond investors, who bear the risks and are highly secured. In this system, Danish homeowners can not only refinance, but can “buy back” their mortgages at a discount if interest rates rise. Essentially, if interest rates rise, the homeowner can repurchase a portion of the covered bond corresponding to their mortgage, and receive a new loan for a smaller principal than the original (but at a higher rate). Because of this system, Danish homeowners have no incentive to hold onto their mortgage in a high-interest rate environment, and thus the problem of “lock in” is avoided.
Key Sources
Gregory Schmidt, Home Buyers Are Eager but Sellers Are Scarce, Creating ‘Real Gridlock’, N.Y. Times (Apr. 29, 2023), https://www.nytimes.com/2023/04/29/business/spring-housing-market.html
Daniel Alpert, Opinion, The Fed Has Put Our Housing Market in Jeopardy, N.Y. Times (Nov. 14, 2023), https://www.nytimes.com/2023/11/14/opinion/federal-reserve-housing-market.html
Todd Zywicki, The Behavioral Law and Economics of Fixed-Rate Mortgages (and Other Just-So Stories), 21 S. Ct. Econ. Rev. 157, 160 (2013)
David Min, How Government Guarantees Promote Housing Finance Stability, 50 Harv. J. on Legis. 437, 480-81 (2013)
Michael Lea, International Comparison of Mortgage Product Offerings, Rsch. Inst. for Hous. America 1, 18 (2010)
Jesper Berg, Morten Baekmand Nielsen, & James Vickery, Peas in a Pod? Comparing the U.S. and Danish Mortgage Finance Systems, Fed. Reserve Bank of N.Y. Econ. Pol’y Rev. 24, No. 3, Dec. 2018, at 68
Aziz Sunderji, Why Denmark’s Housing Market Works Better than Ours, LinkedIn (Sept. 30, 2023)