Question

In the US, 30-year fixed rate mortgages with low prepayment penalties are common, which is not the case in many other countries. This is partially due to the US government involvement with firms like Fannie Mae and Freddie Mac.

Why might the private sector not provide this product? Is it a good thing that the government is intervening in the way that it is?

Answer 1

30 year fixed mortgage was introduced in mid-1950s as a counter to the increase in interest rates by the Federal Reserve. Today, almost 90% of applications for home loan in the US is for 30 year mortgage.

Before i answer your two specific questions, let us analyze the main reason for this high demand for 30 year fixed rate mortgage: paying a loan over extended period makes monthly payments more affordable. When a common person can afford house loans, the demand for housing increases and this pushes the housing prices up. If the government were to suddenly discontinue 30 year mortgage, it will shock the housing market and we can expect the housing rates to fall. This is specially true for first time house owners or entry level home owners.

This affordability, however, comes at a cost - the interest rate that you pay on a 30 year loan is more than 2 times the interest you would pay on a 15 year loan.

Another reason for high demand for 30 year mortgage is that Fannie Mae and Freddie Mac ensure that these loans are supported by a steady stream of funds - they bundle these loans into mortgage-backed securities and guarantee these bonds against any probable default. Let me explain this major point a little better: Bank A lends money to a home owner and the home owner defaults in the loan payment. In this case, Fannie will bear the losses (not Bank A). Fannie did this by the steps explained above. It had government guarantee for their debt so its own risk was not high. This enable it to price insurance reasonably and ended up encouraging more lending. To answer your first question - private sector simply cannot afford doing this without government backing.

Now is it a good thing?

Well, these policies transfer the risks associated with mortgage onto the tax payers instead of financial institutions. These policies have not helped US weather 2008 crisis.

Low monthly payment and almost no penalty for paying extra amount every month makes 30 year mortgage attractive. That is a buyer can pay more and convert a 30 year mortgage to a 20 year mortgage with virtually no penalty. However, the interest rates on these 30 year loan are almost 2.2 times the interest on say a 15 year loan. Result is that the government has encouraged people with low monthly income to buy houses. In the pretext of encouraging home ownership, the government has ended up encouraging mortgage ownership. Also, naturally a borrower with 30 year mortgage will have less equity than a borrower with a shorter mortgage. Another risk is that if housing prices fall, long term borrower may find it difficult to pay off the mortgage with sale proceeds of the house.

Inspite of all this, i will not make a blanket statement that we should do away with 30 year mortgage period. As explained above, it will cause housing prices to go down. Also, no government policy can completely remove risks and the risks are associated with almost every debt product and may vary as per the economy. Lastly, a well functioning economy should have diverse mortgage products available. This not only benefits the economy at large but also helps customers meet their specific needs and limitations. And even in the absence of government backing, there is not guarantee that 30 year fixed rate mortgages won't exist.