A 30-Year Trap: The Problem with America’s Weird Mortgages

Before the pandemic, buying a home was difficult. Somehow it’s getting more and more difficult.

The already sky-high prices have risen even further in the last three years, by almost 40 percent. The available apartments have become scarcer: Offers have fallen by almost 20 percent in the same period. And now interest rates have risen to a 20-year high, eroding purchasing power without – contrary to normal economic logic – doing much to depress prices.

Of course, this is not a problem for people who already own their own home. They had been spared from rising interest rates and, to some extent, rising consumer prices. Their homes are worth more than ever. Your monthly housing costs are largely fixed.

The reason for this gap – at least a large part of it – is a unique, pervasive feature of the U.S. housing market: the 30-year fixed-rate mortgage.

This mortgage has been around for so long that it’s easy to forget how strange it is. Because the interest rate is fixed, homeowners can freeze their monthly loan payments for up to three decades, even if inflation picks up or interest rates rise. However, because most U.S. mortgages can be paid off early without penalty, homeowners can easily refinance when interest rates drop. Buyers get all the benefits of a fixed interest rate, without the risks.

“It’s a one-sided bet,” said John Y. Campbell, a Harvard economist who has argued that the 30-year mortgage contributes to inequality. “When inflation rises sharply, lenders lose and borrowers win. On the other hand, if inflation falls, the borrower simply refinances.”

Elsewhere in the world things are different. In Great Britain and Canada, among others, interest rates are usually only fixed for a few years. This means the pain of higher interest rates will be spread more evenly between buyers and existing owners.

In other countries, such as Germany, fixed-rate mortgages are widespread, but borrowers cannot easily refinance their debts. That means new buyers will have to contend with higher borrowing costs, but so will long-time owners who bought at a time when interest rates were higher. (Denmark has a system comparable to that of the United States, although down payments are generally higher and lending standards are stricter.)

Only the U.S. has such an extreme winner-loser system, in which new buyers face borrowing costs of 7.5 percent or more while two-thirds of existing mortgage holders pay less than 4 percent. For a $400,000 home, that’s a $1,000 difference in monthly housing costs.

“It’s a divided market,” said Selma Hepp, chief economist at real estate site CoreLogic. “It’s a market of the haves and have-nots.”

It’s not just that new buyers have to pay higher interest rates than existing owners. It’s because the US mortgage system discourages existing owners from putting their homes on the market – because if they move to another home, they have to give up their low interest rates and take out a much more expensive mortgage. Many decide to stay put and decide to forego the extra bedroom or put up with the long commute for a while longer.

The result is a frozen real estate market. With few homes on the market — and even fewer at prices buyers can afford — sales of existing homes fell more than 15 percent last year, to their lowest level in more than a decade. Many in the Millennial generation who have already struggled to break into the real estate market are finding they have to wait even longer to buy their first home.

“Affordability, no matter how you define it, is essentially at its worst level since mortgage rates were in the teens,” said Richard K. Green, director of the Lusk Center for Real Estate at the University of Southern California. “We kind of implicitly favor the incumbents over new people, and I don’t see any particular reason why that should be the case.”

The story of the 30-year mortgage begins in the Great Depression. Many mortgages at the time had a term of 10 years or less and, unlike today’s mortgages, were not “self-paying” – that is, rather than gradually paying off the loan amount along with interest each month, borrowers owed the entire principal amount at the end of the term . In practice, this meant that borrowers had to take out a new mortgage to pay off the old one.

This system worked until it didn’t: When the financial system collapsed and property values ​​collapsed, borrowers couldn’t renew their loans. At one point in the early 1930s, nearly 10 percent of U.S. homes were in foreclosure, according to research by Mr. Green and a co-author, Susan M. Wachter of the University of Pennsylvania.

In response, the federal government created the Home Owners’ Loan Corporation, which used government-backed bonds to buy defaulted mortgages and reissue them as fixed-rate, long-term loans. (The company was also instrumental in creating the redlining system, which prevented many black Americans from buying homes.) The government then sold these mortgages to private investors, with the newly formed Federal Housing Administration providing mortgage insurance to these investors knew what loans they had and where the purchase would pay off.

The mortgage system evolved over the decades: the Home Owners’ Loan Corporation gave way to Fannie Mae and later Freddie Mac—nominally private companies whose tacit support from the federal government became apparent after the housing bubble burst in the mid-2000s. The GI Bill led to a huge expansion and liberalization of the mortgage insurance system. The savings and loan crisis of the 1980s contributed to the rise of mortgage-backed securities as the primary source of financing for home loans.

By the 1960s, the 30-year mortgage had become the dominant type of home purchase in the United States—and, except for a brief period in the 1980s, it has remained so to this day. Even at the height of the housing bubble in the mid-2000s, when millions of Americans were lured by adjustable-rate mortgages and low “teaser” interest rates, a large portion of borrowers opted for long-term, fixed-rate mortgages.

After the bubble burst, the variable rate mortgage all but disappeared. Today, nearly 95 percent of existing U.S. mortgages have a fixed interest rate; More than three quarters of these have a term of 30 years.

Nobody wanted to make the 30-year mortgage the standard. It was “a historical coincidence,” said Andra Ghent, an economist at the University of Utah who has studied the U.S. mortgage market. But intentionally or unintentionally, the government played a central role: There is no way for most middle-class Americans to get a bank to lend them several times their annual income at a fixed interest rate without some form of government guarantee.

“To make 30-year loans, you need a government guarantee,” said Edward J. Pinto, a senior fellow at the American Enterprise Institute and a longtime conservative critic of the 30-year mortgage. “The private sector couldn’t have done this alone.”

For home buyers, the 30-year mortgage is an incredible deal. They can borrow at a subsidized interest rate – often while investing relatively little of their own money.

But Mr. Pinto and other critics on both the right and left argue that while the 30-year mortgage may have been good for individual homebuyers, it was not nearly as good for American homeownership as a whole. By making it easier to buy, the government-subsidized mortgage system has stimulated demand, but without paying nearly as much attention to ensuring greater supply. The result is an affordability crisis that long predates the recent rise in interest rates and a home ownership rate that is unremarkable by international standards.

“Over time, the 30-year fixed rate will likely just hurt affordability,” said Skylar Olsen, chief economist at real estate site Zillow.

Research suggests that the U.S. mortgage system has also exacerbated racial and economic inequality. Wealthier borrowers tend to be more financially sophisticated and therefore more likely to refinance if it saves them money. This means that gaps will arise over time, even if borrowers start with the same interest rate.

“Black and Hispanic borrowers in particular are less likely to refinance their loans,” said Vanessa Perry, a professor at George Washington University who studies consumers in housing markets. “Over time there will be a loss of equity. You’re paying too much.”

Hillary Valdetero and Dan Frese are on opposite sides of the great mortgage divide.

Ms. Valdetero, 37, bought her home in Boise, Idaho, in April 2022, just in time to secure a 4.25 percent interest rate on her mortgage. In June, interest rates approached 6 percent.

“If I had waited three weeks, I would have been priced out because of the interest rate,” she said. “With the current condition, I wouldn’t be able to touch a house anymore.”

Mr. Frese, 28, moved back to his hometown of Chicago in July 2022 as interest rates continued their upward trend. A year and a half later, Mr. Frese is living with his parents and saving as much as he can in hopes of buying his first home – and watching as rising interest rates push that dream further and further away.

“My schedule needs to be extended for at least another year,” Mr. Frese said. “I think about it: Could I have done something differently?”

The different fates of Ms. Valdetero and Mr. Frese have implications beyond the real estate market. Interest rates are the Federal Reserve’s main tool for curbing inflation: When borrowing becomes more expensive, households are supposed to cut back on spending. But fixed-rate mortgages blunt the impact of these policies — meaning the Fed will have to be even more aggressive.

“If the Fed raises interest rates to control inflation, who feels the pain?” asked Mr. Campbell, the Harvard economist. “In a fixed-rate mortgage system, you have this whole group of existing homeowners who aren’t feeling the pain and can’t bear the burden, so the burden falls on new homebuyers,” as well as renters and builders.

Mr Campbell argues there are ways to reform the system, starting with encouraging more buyers to opt for variable rate mortgages. Higher interest rates are doing this, but very slowly: the proportion of buyers using the variable option has increased from 2.5 percent at the end of 2021 to around 10 percent.

Other critics have suggested more extensive changes. Mr Pinto has proposed a new type of mortgage with shorter terms, variable interest rates and minimal down payments – a structure he said would improve both affordability and financial stability.

But in practice, hardly anyone expects the 30-year mortgage to disappear any time soon. Americans hold $12.5 trillion in mortgage debt, mostly in the form of fixed-rate loans. The existing system has an enormous – and enormously wealthy – built-in constituency, whose members are certain to fight any change that threatens the value of their greatest assets.

It is more likely that the frozen real estate market will gradually thaw. Homeowners will decide they can no longer put off selling, even if it means a lower price. Buyers will also adapt. Many forecasters predict that even a small drop in interest rates could lead to a big increase in activity — a 6 percent mortgage suddenly doesn’t sound so bad.

But that process could take years.

“I’m very happy that I came in at the right time,” Ms. Valdetero said. “I’m really sorry for the people who didn’t get in and now can’t.”