Why the Universal Use of the 30-Year Mortgage Is Dangerous
The short answer is that the 30-year mortgage amortizes extremely slowly, making it nearly twice as risky as a similar loan with a 20-year term. And the 30-year loan compounds risk-layering by promoting the use of higher combined loan-to-value and debt-to-income ratios (DTI).
The Housing Lobby unabashedly supports the broad availability of the 30-year mortgage, and even wants it extended to manufactured housing. This is because Housing Lobby sees the slow amortization as a feature that reduces monthly payments, making home “more affordable”. They choose to ignore the bug--the 30-year loan, when combined with other risk factors, drives up home prices when the supply of homes is tight, especially for buyers of entry-level homes. Since 2012, lower priced entry-level homes have risen by about 55%, while move-up homes have risen by about 31%. This means lower priced entry-level homes that cost an average of $103,315 in 2012, cost a whopping $160,138 in late-2018. Thus, rather than making housing more affordable as its supporters claim, 30-year loans make housing less affordable. But more on this entry-level home pricing penalty later.
Let’s review the facts about the 30-year loan:
Fact 1: In December 2018, 30-year loans constituted 99% of all government guaranteed loans to finance a home purchase. Government agencies guaranteed 85% of home purchase loans.
Fact 2: This was not always the case. In 1953, the year before Congress authorized the FHA to insure 30-year loans on existing homes, FHA’s average loan term was 21 years and conventional loans had a term of 15 years. Even as recently as 1992, 27% of home purchase loans had a term of 15- or 20-years.
Fact 3: 30-year loans are much riskier than the 15- and 20-year loans they replaced. In general, a 30-year loan is about twice as risky as a 20-year loan with similar risk characteristics. A 15-year loan has about 60% less risk than a 30-year loan with similar characteristics. With the loans terms prevalent in the 1950s, it comes as no surprise that foreclosure levels in the 1950s literally rounded to zero. With the broad adoption of the 30-year loan by FHA in the late 1950s and early 1960s, foreclosure rates started to rise to concerning levels in the early 1960s.
Fact 4: The prominent feature of 30-year loans is its lower or “easier” monthly payment compared to say a 20-year loan. For example, the monthly payment at 4.5% on $100,000 is $507 for a 30-year loan, compared to $633 for a 20-year loan, an increase of 25% per month.
Fact 5: But it is the 30-year loan’s lower monthly payment that is its flaw. The pace of principal pay-down on a 30-year mortgage is agonizingly slow. At the end of 6 years, the balance on the 30-year loan is $89,138, compared to $78,749 for the 20-year loan. This helps explain why the 30-year loan is so much riskier. The paying down of principal through scheduled amortization is called earned equity. House price appreciation through rising prices, particularly when rising faster than inflation, is call unearned equity. Since the long term success of the 30-year loan as a wealth building tool is reliant on large doses of unearned equity on entry level-homes, it is fatally flawed.
Fact 6: History has shown that the 30-year’s lower monthly payment does not make homes more affordable. Instead, it leads to faster median home price growth relative to median incomes. Back in the 1950s, before the large-scale adoption of the 30-year loan, the median home price was about 2 times median income. Today, this ratio is over 3.5. This result is predictable, as Ernest Fisher, FHA’s first chief economist in the 1930s and a university professor in the 1950s, observed that in a seller’s market, “more liberal credit is likely to be [capitalized] in price.”
Fact 7: As the easy terms of the thirty-year loan gets capitalized into higher home prices, the dollars needed for a down payment of say 10% doubles as the price of a home doubles. Yet as already noted, incomes (and savings) do not rise as quickly. At the start of the current home price boom in 2012, first-time FHA buyers had a median down payment of $3800. In January 2019 the median down payment was still $3800, yet the median home price purchased had increased by 31%. This translates into more risk.
Fact 8: A similar trend has occurred with respect to borrower DTIs. Since 2012, the DTIs of first-time FHA buyers have increased by 13%, an unsurprising result since wages have increased by only about 16% over the same period, but the price of homes purchased went up by 31%.
Fact 9: The impact on the level of risk different borrowers take may be quantified. Loans to first-time buyers that are guaranteed by Federal agencies have an average mortgage risk score of 17%, almost double the rate of 9.9% for repeat buyers.
Fact 10: As noted previously, since 2012 the constant quality price of entry-level homes has risen by about 55%, while move-up homes have risen by about 31%. Had the low segment risen at the same rate as the move-up segment over this period, the average entry-level buyer would be spending $24,800 or 15.5% lessfor a home today. At this lower price, not only would homes be more affordable but they would require smaller down payments and low DTIs, thereby reducing the risk of foreclosure.
The solution is simple. Stop putting FTBs in harm’s way and end the pricing penalty. This can be done by switching to a 20-year loan term that builds wealth more reliably and at much lower risk of default. Second, adopt policies to increase the supply of newly constructed entry-level homes.