US market distortions put spotlight back on 30-year mortgage debate

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There are many metrics to show how distorted the US housing market has become. Despite borrowing costs hitting 20 year highs, prices are hovering near record levels with benchmarks of the affordability of home ownership at the lowest levels in more than 30 years. Sales activity has slumped to levels not seen outside major financial crises.

Could an unusual but much lauded feature of the US housing market have contributed to the situation?

Thirty-year, fixed-rate mortgages dominate in the US and are chosen by around 90 per cent of all homebuyers. To their fans, they are a cornerstone of the American dream. In almost everywhere else in the world, home buyers can only dream of one as they pay mostly floating rates or face shorter repayment terms. In the US, they are largely possible only through government intervention, since many of the loans end up being guaranteed by government agencies Fannie Mae and Freddie Mac.

But they have become a hot topic in the US because of the sharp drop in houses for sale. With about three-quarters of homeowners paying 4 per cent or less on their mortgages, they are “trapped” in their current homes because a new mortgage means paying more than 7 per cent. This has depressed the number of houses for sale, supporting high prices.

A recent critical column in the New York Times on 30-year mortgages prompted a punchy response in The Nation days later from economist James Galbraith. Supporters such as Galbraith contend that homeowners deserve protection and that lenders have far more ways to lay off the risks of a loan.

“It just reduces the uncertainty of homeowning, which of course was the point,” he says. “What you get as the borrower is assurance that for whatever indefinite period you (choose) . . . you’re not subject to the downside risk.”

Detractors warn that apart from limiting supply of properties on to the market when interest rates are rising, 30 year mortgages can push up house prices since spreading repayments over a longer term, than say the 20 years more common in other countries, raises the total amount a borrower can afford to borrow, allowing them to bid more.

These factors make life harder for lower-income borrowers, including first-time buyers, who face a market with fewer suitable homes and strained affordability.

Since 2012, low-priced homes tracked by the American Enterprise Institute, have seen prices rise 150 per cent, about half as much again as houses in a medium-high priced bucket. Supply is a big factor: the low-priced end of the market is not developers’ most profitable price point.

The price rises have strained debt levels relative to income, setting up a greater number for defaults. Foreclosures are more likely in the early years of any mortgage when maintaining payments is often a greater struggle. Its also the period during which the structure of 30-year loan payments hurts most: since interest is charged on the outstanding loan amount, more of each payment covers that, not equity, in those early years, leaving a booted-out borrower with less for their efforts.

Five years of paying a 30-year loan of $326,000 — the top of the AEI’s low price bucket — at the current new mortgage average rate of 7.17 per cent would net a borrower about $19,000 of equity in that time, not including any price appreciation or down payment. Had the loan term been 20 years instead, a borrower would have $44,000 paid off because the overall interest bill is so much smaller. 

“The low end is like a rollercoaster, whereas the higher end is more like gliding through as they have the staying power — the better credit and the lower debt service (levels),” says Edward Pinto, head of the AEI’s Housing Center and a longtime critic of the fixation with 30-year mortgages. “Lower-income borrowers are usually last in during a market upcycle and lower-priced homes tend to have more (price) volatility.”

However, the 30-year fixed-rate deals don’t appear to have had much of an impact on actual home ownership levels. About two-thirds of Americans have a mortgage or own their place outright, according to the OECD. That’s in line with Canada and the UK — two countries similarly keen on home ownership but which typically offer short-term fixed-rate “teasers” before reverting to floating rates. 

For all the heated debate, changes to this particular piece of American exceptionalism seem unlikely any time soon, not least as the US enters an election year. Americans are also extremely fond of their fixed-rate certainty. “Its just so nice,” said one American, a fellow FT columnist, of his home loan. It may not have the strongest financial foundations, but that feeling is probably the biggest block to any change.

jennifer.hughes@ft.com