When it comes to financing the purchase of a home, there is an option that is a gold standard, and then there is everything else.
That option is a 30-year fixed-rate mortgage (FRM). And it is so uniquely American in its ideology.
“The 30-year FRM isn’t widely available in other countries,” said Ken Fears, Senior Policy Advisor for the Advocacy Group at the National Association of REALTORS® (NAR). “It’s a huge advantage for consumers because it allows them to have a better idea of how to manage their finances. Equity isn’t built as quickly, but it provides a lower, more stable payment.”
A 30-year mortgage is a home loan that will be paid off completely in 30 years if you make every payment as scheduled. Most 30-year mortgages have a fixed rate, meaning that the interest rate and the payments stay the same for as long as you keep the mortgage.
About 90 percent of homeowners who have a mortgage choose the 30-year FRM, according to data from NAR’s Homebuyers and Sellers Generational Trends Report that was released in August.
The 30-year FRM was adopted by the Federal Housing Administration (FHA) in the 1950s to counter actions taken by the Federal Reserve.
The Fed started raising interest rates in 1954 after decades of buying Treasury debt to artificially hold down long-term treasury rates.
At the time, 20-year mortgages were en vogue, but moving to a 30-year mortgage lowered the monthly payments and successfully cancelled out the two percent rise in rates that took place over the first 10 years of the 30-year mortgage’s existence.
By the early 1960s, the 30-year FRM became standard with the FHA. In the Savings and Loan industry, it took about another decade before it became standard there as well. And an overwhelming majority of Americans use them today.
And why not? There are so many benefits for the consumer to procuring a 30-year FRM when buying a home.
- Lower payment: As previously mentioned, a 30-year FRM allows for the buyer to lock in a fixed interest rate for the life of the mortgage, guaranteeing cost certainty and an easier management of individual or familial budgets.
- Flexibility: If a borrower’s financial situation improves, they have the option to pay off the loan faster by paying more each month or making extra payments. But, the borrower can always fall back to making the minimum payment, if needed, at any time over the life of the repayment period.
- Predictability: The economy might fluctuate. Interest rates may skyrocket. But borrowers can breathe easy knowing that their payment won’t change despite those unpredictable variables in the market.
- Affordability: Having a guaranteed lower payment could allow a buyer to purchase a slightly larger home than they thought they could afford knowing that the payment won’t go up and outside their budget at any point down the road.
- Tax Benefits: Depending on the state, tax laws allow homeowners to deduct mortgage interest from their taxes. In the first few years of a loan, a majority of payments go toward paying off the interest on the loan, this usually leads to a more substantial deduction come tax season.
- More likely to Qualify: Smaller payments make it easier for more borrowers to become eligible for a 30-year mortgage.
- Prevents House Poverty: Rather than be in a home and financially strapped, after the mortgage is paid each month, there’s more money left for other goals, whether they be project or entertainment-based.
“Quite simply, it’s a bread and butter product,” Fears said. “Our parents used it. We’re familiar with it. There’s no reason to change it.”
And yet, there are some who would want to see it go away. There is ongoing discussion inside the FHA and the agencies it regulates – Fannie Mae and Freddie Mac – as to whether there needs to be reform to mortgages, and if so, what would they look like?
Detractors argue that a 30-year FRM has a negative impact on homeowners because lender’s charge higher interest rates on a 30-year mortgage because of a greater assumed risk of not being repaid. Additionally, when paying on a 30-year mortgage, there is more interest being paid, creating a higher total cost when compared with a shorter-term loan.
Also, those who support eliminating the 30-year FRM as part of an overhaul to the system cite a slower growth in home equity and also has a psychological impact because it might make people overborrow to get into a bigger home than they can really need. Add to that the greater need for home upkeep and possibly even higher utility bills.
But is change really the best answer?
“We’re concerned as an institution that if you mess with a system that’s worked well, many underserved markets will be affected negatively,” Fears said. “People of color and urban areas as well as small towns and rural markets – which make up huge swaths of the U.S. – these are the engines of middle-income home ownership. They need the 30-year FRM.”
Additionally, middle-income individuals and families are the lifeblood of an economy. They spend money at local businesses. If they can’t afford to do that, the local economy starts to suffer. When that happens, it impacts taxes, school districts, infrastructure, community safety – it’s a vicious cycle.
Other options do exist. There’s a 15-year FRM, which is identical to the 30-year, only it resolves itself in half the time. Then there are adjustable rate mortgages (ARM) which fluctuate on the interest percentage based on the economy and the whims of the Fed when it sets insurance rates.
“We are living in a rising rate environment,” Fears said. “Yes, it has fallen for the last for six months (March-September, 2019), but the rates had been rising before that, and they are going to rise again in the next 10 years. Our government is spending more money and rates are going to rise.”
Fears added that the problem with the 15-year FRM is that despite sandwiching the payments down, borrowers are now paying it off twice as fast – nearly doubling each monthly payment and swallowing up the income of the buyer. This often puts the buyer way over their debt-to-income caps.
“If you have wealth or have been in your home 10-15 years and you are trading up and have equity for a large down payment, that’s the only way it makes more sense,” Fears said.
As for an ARM, they are usually more beneficial for people who move frequently, or who flip properties, or even own a home as a rental property because they can recoup the changes in their mortgage payment as part of their investment in the property.
According to a report from the Urban Institute, ARM’s spiked during the subprime mortgage crisis but have levelled out since. The NAR Generational Trends report indicated that only two percent of all buyers who finance their mortgages use ARM’s in 2019.
“The share of ARMs surged at the peak of the subprime period because lenders were being paid more to originate ARMs based on the assumption that rising home prices would allow borrowers to refinance,” Fears said. “In short, the high share was an anomaly.”
Furthermore, ARMs are incredibly volatile for the average homeowner because despite a lower monthly payment in the beginning, usually within five years the payment will have exceeded, sometimes substantially, that of an FRM.
“A buyer might be comfortable with having higher future monthly payments based on their current financial situation,” Fears said. “But what happens if they need to do some belt-tightening down the road? Will they have the reserves? There are so many variables that a borrower just doesn’t plan for. What if they or someone in their family has an illness? What if their kids switch from public to private school? What if they have another child?
“There are so many life-altering things that can happen that could have an adverse impact on what someone can afford to pay. Having a reliable, fixed rate and fixed-payment on a mortgage helps to defray some of those potential life surprises.”
It’s why an overwhelming majority of homebuyers choose the 30-year FRM to finance their purchase. It’s safe. It’s reliable and it won’t increase over time.
It’s a part of the ethos of America. And it should be for generations to come.