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The Perils of America’s Unusual Mortgage System: 30 Years of Entrapment

Purchasing a home was challenging before the pandemic and has become even more so. Housing prices have sharply risen, nearly 40 percent over the past three years. However, the available homes on the market have dwindled by almost 20 percent over the same period. Additionally, interest rates have surged to a 20-year high, reducing buying power without significantly impacting prices.

This situation, of course, does not affect current homeowners. They have been shielded from rising interest rates and, to some extent, from escalating consumer prices. The values of their homes have increased, and their monthly housing expenses are mostly fixed.

A major factor contributing to this divide is the prevalent U.S. housing market feature: the 30-year fixed-rate mortgage.

This mortgage, which has been widespread for a considerable time, allows homeowners to freeze their monthly loan payments for up to three decades, even if inflation and interest rates rise. Moreover, since most U.S. mortgages can be refinanced without penalty, buyers can enjoy the benefits of a fixed rate without the associated risks.

Harvard economist John Y. Campbell has described this as “a one-sided bet.” According to Campbell, in a scenario where inflation soars, lenders lose while borrowers win. Conversely, if inflation drops, the borrower can simply refinance. This setup is unparalleled in other countries such as Britain and Canada, where interest rates are typically fixed for only a few years, ensuring that the impact of higher rates is more evenly distributed among buyers and existing owners.

In contrast, in countries like Germany, fixed-rate mortgages are common, but borrowers cannot easily refinance. Consequently, both new buyers and long-time owners who purchased their homes when rates were higher contend with elevated borrowing costs. The United States stands out with its extreme system where new buyers face borrowing costs of 7.5 percent or more, while two-thirds of existing mortgage holders pay less than 4 percent, translating to a significant difference in monthly housing expenses for a $400,000 home.

Selma Hepp, chief economist at CoreLogic, describes it as “a bifurcated market” – one of haves and have-nots.

The issue is not just the higher interest rates faced by new buyers compared to existing owners, but also how the U.S. mortgage system dissuades existing owners from selling their homes. This is because moving to a new house would mean giving up their low interest rates for a much costlier mortgage. As a result, many are choosing to stay put, even if it means living in a smaller space or enduring a longer commute.

Consequently, the housing market is at a standstill. With few affordable homes on the market, sales of existing homes have plunged by over 15 percent over the past year, reaching their lowest level in more than a decade. Many millennials, already struggling to break into the housing market, are finding themselves having to wait even longer to purchase their first homes.

Richard K. Green, director of the Lusk Center for Real Estate at the University of Southern California, points out that “affordability, no matter how you define it, is basically at its worst point since mortgage rates were in the teens” in the 1980s. He questions the implicit favoritism given to incumbents over new people and sees no particular reason for this to be the case.

The origin of the 30-year mortgage dates back to the Great Depression. At that time, many mortgages had terms of 10 years or less and were not “self-amortizing.” As a result, borrowers had to take out a new mortgage to pay off the old one, which became problematic when the financial system seized up and home values plummeted. As a consequence, the federal government created the Home Owners’ Loan Corporation, which reissued defaulted mortgages as fixed-rate, long-term loans using government-backed bonds. This initiative and subsequent developments over the decades led to the dominance of the 30-year mortgage in the U.S. housing market.

The mortgage system evolved over time, eventually leading to the emergence of Fannie Mae and Freddie Mac. The G.I. Bill also played a significant role in expanding and liberalizing the mortgage insurance system, while the savings-and-loan crisis of the 1980s contributed to the prevalence of mortgage-backed securities as the primary source of funding for home loans. Over the years, the 30-year mortgage has remained the dominant method for purchasing a house in the United States.

Today, nearly 95 percent of existing U.S. mortgages have fixed interest rates, with over three-quarters of them being for 30-year terms.

According to Andra Ghent, an economist at the University of Utah, the 30-year mortgage’s rise to standard status was somewhat accidental. The government played a crucial role, as most middle-class Americans wouldn’t have been able to secure a bank loan at a fixed rate for a high multiple of their annual income without some form of government guarantee.

Senior fellow at the American Enterprise Institute, Edward J. Pinto, points out that government guarantee is necessary for 30-year lending as the private sector couldn’t achieve this on its own. For home buyers, the 30-year mortgage offers an advantageous deal, allowing them to borrow at a subsidized rate with relatively low personal investments.

Critics from both the right and left argue that while the 30-year mortgage may benefit individual home buyers, it has not been as favorable for American homeownership overall. The government-subsidized mortgage system has stimulated demand without adequate attention to increasing supply, leading to an enduring affordability crisis and a homeownership rate that is unimpressive by international standards.

Research indicates that the U.S. mortgage system has exacerbated racial and economic inequality, with wealthier borrowers being more likely to refinance, leading to financial gaps over time, particularly affecting Black and Hispanic borrowers who are less likely to refinance and consequently overpay.

The divergent experiences of Hillary Valdetero and Dan Frese illustrate the impact of the fixed-rate mortgage system. Ms. Valdetero was able to secure a 4.25 percent interest rate for her home in Boise, Idaho, while Mr. Frese, facing rising rates, is residing with his parents in Chicago, saving for his first home but seeing his dream being pushed further away due to increasing interest rates.

The Federal Reserve uses interest rates as a tool to control inflation. However, fixed-rate mortgages mitigate the impact of such policies, necessitating more aggressive measures from the Fed. Critics suggest changes to the system, such as encouraging more buyers to opt for adjustable-rate mortgages or proposing new mortgage types with shorter durations, variable interest rates, and minimal down payments to enhance affordability and financial stability.

Most observers believe that the 30-year mortgage is unlikely to disappear soon, given the huge and powerful constituency with vested interests in the current system. However, the frozen housing market is expected to gradually thaw, as homeowners may decide to sell despite lower prices, and buyers will adjust to the conditions. A drop in rates could lead to a considerable upsurge in housing market activity, albeit over a prolonged period.

Ms. Valdetero expressed feeling fortunate for purchasing at the right time, acknowledging the challenges faced by those who missed the opportunity.

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