The Perils of America’s Unusual Mortgage System: 30 Years of Entrapment

Buying a home was difficult before the pandemic. It continues to be even harder.

Prices, which were already very high, have increased by nearly 40 percent over the past three years. The number of available homes has decreased by almost 20 percent over the same period. Additionally, interest rates have now reached a 20-year high, reducing purchasing power without significantly affecting prices. This creates a problem for potential buyers rather than homeowners, who are protected from rising interest rates and, to some extent, from increasing consumer prices as their homes have increased in value and their monthly housing costs remain stable.

A major reason for this divide is the unique and widely used feature in the U.S. housing market: the 30-year fixed-rate mortgage.

This mortgage, common for an extended period, allows homeowners to lock in their monthly loan payments for up to three decades, regardless of inflation or rising interest rates. While borrowers can refinance if rates go down due to the absence of penalties for early mortgage repayment, they receive all the benefits of a fixed rate with none of the risks.

John Y. Campbell, a Harvard economist, describes it as “a one-sided bet” and argues that the 30-year mortgage contributes to inequality. This system is unique to the United States, where new buyers face borrowing costs of 7.5 percent or more while two-thirds of existing mortgage holders pay less than 4 percent. This results in a difference of $1,000 in monthly housing costs for a $400,000 home.

This imbalance not only forces new buyers to face higher interest rates than existing owners, but also discourages existing homeowners from selling their homes. This is because moving to another house would mean giving up their low interest rates and acquiring a much costlier mortgage. Consequently, many choose to stay put, impacting the housing market by reducing the number of homes for sale and driving down existing home sales by over 15 percent in the past year.

The frozen housing market, with few affordable homes on the market, is making it harder for millennials to enter the housing market and buy their first homes.

Furthermore, the U.S. mortgage system is not just impacting individual buyers, but also contributing to broader economic issues such as racial and economic inequality, as wealthier borrowers are more likely to refinance, creating gaps in interest rates over time.

The 30-year mortgage began in the Great Depression, when the federal government created the Home Owners’ Loan Corporation to address the foreclosure crisis. This led to the establishment of fixed-rate, long-term loans, eventually becoming the dominant method for purchasing homes in the United States.

Today, nearly 95 percent of existing U.S. mortgages have fixed interest rates; of those, more than three-quarters are for 30-year terms.

However, while the 30-year mortgage offers favorable terms for homebuyers, critics argue that this system has contributed to long-standing issues of affordability and an unremarkable homeownership rate.

The diverging fortunes of homeowners and potential buyers have led to implications beyond the housing market. Fixed-rate mortgages dampen the effect of the Federal Reserve’s efforts to control inflation, necessitating more aggressive actions to curb inflation. Critics have proposed reforms to encourage more buyers to choose adjustable-rate mortgages, but the 30-year mortgage is unlikely to disappear soon, as it has a large and influential constituency.

While the frozen housing market may gradually thaw, the process of adjustment could take years. Potential buyers will need to adapt, and homeowners may decide to sell, leading to changes in the market.

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