Economics

The Dark Side of the 30-Year Fixed-Rate Mortgage, Part II

Alex Pollock wrote recently on the Enterprise Blog about “The Dark Side of the 30-Year Fixed-Rate Mortgage,” which is especially a problem for borrowers in periods of falling interest rates and home prices. A good example is the period between 2006 and 2010, when home prices plummeted by more than 30 percent and the rates on 30-year fixed-rate mortgages (FRMs) fell from 6.75 percent to 4.25 percent. The falling home prices prevented many homeowners from refinancing to take advantage of the 2.5 percent drop in interest rates, and they were stuck with high interest rates and high monthly payments on property that was falling in value—that’s one dark side of the 30-year fixed-rate for borrowers.

There’s also another, probably better-known dark side to the 30-year fixed-rate mortgage for lenders, in the form of interest-rate risk imposed on the commercial banks and savings and loans banks (S&Ls) who issue and hold those long-term 30-year FRMs and finance them with short-term deposits, i.e. “borrowing short and lending long.” Whereas the dark side of the FRM results from falling interest rates, the dark side of 30-year FRMs for lenders comes during a period of rising interest rates, illustrated best by the rising interest rates of the 1970s (see nearby chart). From 1982 to 1992, approximately 3,000 U.S. commercial banks and S&Ls failed, in large part because the rising interest rates meant many banks were paying out higher rates on their short-term deposits (one-year rates were as high as 15 percent in the early 1980s, see chart) than they were earning on their billions of dollars of 30-year FRMs, many issued at between 6 to 8 percent in the 1960s and 1970s. Although there were other factors that contributed to the thousands of bank failures during the S&L crisis, it’s generally accepted that interest-rate risk played a major role in that banking crisis, and clearly demonstrates the dark side of FRMs for lenders.

Bottom Line: Whether interest rates are rising or falling, there’s going to be a dark side to the 30-year FRM for either the borrower or the lender, and that’s why it’s a mortgage product that doesn’t exist in most other countries. Under a more typical mortgage market like in neighboring Canada, mortgage rates aren’t fixed for three decades, but adjust every five years or less, which eliminates the dark side of the 30-year FRM for both borrowers and lenders. Consider that Canada: a) didn’t experience a single bank failure during our S&L crisis, b) didn’t experience a single bank failure during the recent U.S. financial meltdown, and c) has never offered 30-year FRMs and yet has a higher homeownership rate than the United States. Maybe one lesson from Canada is that bank stability and high rates of homeownership are clearly possible without 30-year FRMs, and the “shining religious aura” in the United States for the 30-year FRM is very much unwarranted.

Comments are closed.