Moving On From Fixed Rate Mortgages


Arnold Kling has some interesting thoughts on 30-year fixed-rate mortgages today.

1. The U.S. is the only country with the 30-year fixed-rate mortgage. Other countries get along fine without it.

2. The core of my argument against the thirty-year fixed-rate mortgage is that without government intervention I believe that more borrowers would prefer mortgages where the interest rate is fixed or a shorter period, like five years.

The thirty-year fixed-rate mortgage includes both a default option and a prepayment option. The less money you put down, the more valuable the default option. The lower the cost of originating a new mortgage, the more valuable the prepayment option. Origination costs have fallen considerably over the past twenty years, especially when calculated as a percentage of the loan amount.

Thus, both options have become more valuable in recent years. My guess is that both of these options have been under-priced, due to government intervention. Government subsidizes these options by providing support to FHA, Freddie Mac, and Fannie Mae, as well as by tilting bank capital requirements to subsidize securitized loans that include these options.

I claim that in a completely market-driven mortgage market the interest rate on mortgages with little or no money down would be quite a bit higher than the interest rate on mortgages where the borrower makes a down payment of 10 percent or more. Moreover, my guess is that the interest rate on a mortgage where the interest rate stays fixed for thirty years would be much higher than the rate on a mortgage that stays fixed for five years, because the prepayment option on the latter is less valuable.

If borrowers were confronted with the true cost of the default option, fewer people would buy houses with little money down. Instead, they would choose either to rent or to save up for a large down payment.

If borrowers were confronted with the true cost of the prepayment option, fewer people would elect thirty-year fixed-rate mortgages. Instead, they would elect, say, mortgages with interest rates fixed for five years.

Before you jump to the standard arguments in favor of fixed-rate mortgages, read the rest of his post.

I doubt it will happen, but it would be refreshing to hear arguments such as this advanced not just by economists like Kling but from some of our elected representatives as welrsl.

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