Thursday, July 27, 2017

Fannie and Freddie don't really do 30-year mortgages

The reason is prepayment.  I just happened to notice recently that even in periods where there isn't an interest rate incentive for people to prepay their mortgages, lots of people do.  As this piece in Mortgage News Daily shows, conditional prepayment rates on GSE secured loans are essentially always above 10 percent, regardless of market interest rates.  When people have mortgages whose rates are lower than market rates, some still prepay, either to move, or to get cash, or to consolidate debt.

At a 10 percent conditional prepayment rate, 65 percent or mortgages are paid off in less than 10 years (and when one adds in amortization, 73 percent of mortgage balances are paid off, assuming a rate of 4 percent).  Of course, 10 percent is the minimum, so actual mortgage payoffs are much higher than 65 percent.

One of the justifications (and one I have used myself) for GSEs is that they allow borrowers access to 30-year, fixed rate mortgages.  Consumers generally pay more for the very long term--a payment that may be justified as an insurance premium.  But if very few people use the insurance, it is not clear whether the cost is worth it to consumers.  At the same time, because of slow amortization, the 30-year mortgage--particularly one that is being refinanced regularly, is not a great savings commitment device.

Perhaps a better product for consumers would be a 7-year adjustable rate mortgage, or even better, a 7-year ARM with a 20 year amortization term.  The 30 year mortgage arose as an affordability product when interest rates neared and exceeded double digits, and was a good product for those times.  But in a world of very low interest rates, it may no longer be the gold standard for consumers.  And so if we are to ever get to housing finance reform, perhaps the next model of housing finance should be very different from today's.      

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