There’s a lot of pundit-love and wonk-love for the 30-year-fixed rate mortgage, particularly on the left. It’s such a nice, safe, stable product. That’s why it’s generally thought of as the “vanilla option” for mortgages that Senator Elizabeth Warren, among others, has long been pushing. After all, once you lock in your rate, you’re safe. Who could be against setting things up so that most people avail themselves of that safety?
A small group of conservatives and financial engineering types retort that there’s a lot to dislike about the 30-year fixed-rate mortgage. It’s not clear that this is a product found in nature; most other countries don’t have them, which suggests that this mortgage requires a federal guarantee (explicit or implicit) to make it cheap enough for people to be interested. For that ability to lock in your interest rate is not free; over the past year, for example, the official blog spouse and I have probably paid thousands more on our fixed-rate mortgage than we would have on a 2/2 conforming adjustable rate mortgage, or ARM. And so have you, if you’re in a fixed rate. Hopefully, we’ll all make it up later, when interest rates rise -- but the fact remains that you have to pay your lenders an interest rate premium in order to get them to bear the interest rate risk.
These arguments don’t arouse much interest in most people; they think the interest rate insurance is worth it. In my experience, many of them also associate ARMs with the housing bubble, so there’s an uneasy sense that anything that became very popular in 2005 was probably a bad idea. And to be fair, you can see why they’d think so.
So here’s another reason that we might prefer ARMs to fixed-rate mortgages: Whatever role they played in goosing housing on the way up, they may also have eased defaults on the way down. A new paper from Andreas Fuster and Paul S. Willen notes that during the housing crisis, people with ARMs saw their payments fall by about half, on average, because interest rates fell so far. And here’s what that meant:
Surprisingly little is known about the importance of mortgage payment size for default, as efforts to measure the treatment effect of rate increases or loan modifications are confounded by borrower selection. We study a sample of hybrid adjustable-rate mortgages that have experienced large rate reductions over the past years and are largely immune to these selection concerns. We show that interest rate reductions dramatically affect repayment behavior, even for borrowers who are significantly underwater on their mortgages. Our estimates imply that cutting a borrower’s payment in half reduces his hazard of becoming delinquent by about 55 percent, an effect approximately equivalent to lowering the borrower’s combined loan-to-value ratio from 145 to 95 (holding the payment fixed). These findings shed light on the driving forces behind default behavior and have important implications for public policy.
Earlier work had indicated that negative equity was a major factor in defaults. Fuster and Willen are suggesting that this result is sensitive to the size of the payment; if the interest rate is low, people are more likely to keep paying even though their mortgage is underwater. This has important policy implications. Concretely, it means that the Home Affordable Refinance Program, by allowing people to refinance into lower-interest rate mortgages, was probably a very cost-effective way to reduce default.
On a more theoretical level, this suggests that ARMs will magnify the effect of monetary policy, while fixed-rate mortgages blunt it. In a land of ARMs, every decrease in the interest rate translates into money in the pocket of the average homeowner, and a lower risk of default for banks. In a land of fixed interest rate mortgages, you maybe get the same effect through refinancing, but it’s expensive and cumbersome and people whose mortgages are underwater won’t enjoy the benefit.
Of course, there’s also the risk that interest rates will rise -- but this is very unlikely to happen at the bottom of a recession. Instead, it probably happens when the economy is growing rapidly, and people are better able to afford it. ARMs are a sort of natural macroeconomic stabilizer, one that may have prevented the housing bust from being much worse than it was.
The reason that they feel so risky and irresponsible is that we’re used to 30-year fixed rate loans. That meant that at the very height of the bubble, people used ARMs to get into houses that they couldn’t really afford -- they could afford the teaser rate, but not the expected payment after the loan reset. The idea, crazy as it now seems, was to build some equity and sell if you really had to. Or something -- it’s not always clear what people who took these loans were thinking.
But this was really a problem with the banks, which made irresponsible loans, not with ARMs per se. If ARMs had been more normal, both people and banks would have paid closer attention to their ability to pay over the long term. In other words, the fault is not in our ARMs, but in ourselves.