Don't Mourn the 30-Year FRM

Discussions of housing finance give a shining religious aura to 30-year fixed-rate mortgages. They are the last refuge of the defenders of Fannie Mae and Freddie Mac, who argue that we have to have government guarantees so we can have 30-year FRMs. First, this argument is wrong. Second, the 30-year FRM is not the unmitigated blessing the Fannie and Freddie loyalists imply. Indeed, it is a big reason U.S. mortgage markets are in such bad shape.

No instrument is universally good in all times and economic situations. Let us consider not only the advantages, but also the dark side of the 30-year FRM. For borrowers of 30-year FRMs, the advantageous situation is when interest rates and house prices alike are rising. Then borrowers have the same mortgage payments despite rising interest rates, and get to keep the whole inflationary premium in the house price.

But suppose interest rates fall to very low levels and house prices also fall. This is the reality of the last few years. The borrowers often cannot refinance because of the fall in house prices, so they are stuck with a very high nominal and even higher real interest rate, and their payments stay the same despite falling interest rates. The entire deflationary discount in the house price is imposed on them. Defaults rise; house prices are pushed further down. In this situation, it becomes quite difficult to modify the 30-year FRMs that cannot be refinanced, as the many government modification programs have demonstrated. In contrast, a floating-rate mortgage, say of the typical British variety, does not need to be modified-the interest rate automatically falls with market rates. This relieves the cash payment burden on the borrowers and shares the deflationary discount with the lenders.

Of course, American mortgage borrowers and lenders did not expect house price deflation and interest rates near zero, but they got them anyway, in large part because they believed in house price inflation. No loan is the best for all seasons, alas.

Alex J. Pollock is a resident fellow at AEI.

Photo Credit: Flickr user respres/Creative Commons

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