Why do we have a 30-year mortgage, anyway?
The average interest on a 30-year, fixed-rate mortgage rose just a hair this week, to 4.86 percent. That’s almost a full percentage point higher than this time last year, according to Freddie Mac. Higher interest rates are changing the home-buying equation as people weigh the costs of borrowing. In some markets, prices have even started to dip — sales, too. But one thing remains constant: The vast majority of new mortgages in this country are of the 30-year fixed variety. Ever wonder why?
“The 30-year term did not come down on a tablet, engraved, that says 30 years is the right number,” said Edward Pinto with the American Enterprise Institute’s Center on Housing Markets and Finance.
So much for the biblical explanation. The 30-year mortgage actually came about because of a housing crisis. Yeah, not that housing crisis. One in the last century. Back in the 1920s, said Cornell University historian Louis Hyman, a typical mortgage was for three to five years, with a variable interest rate, and payments covered only the interest.
“Which means that at the end of that time you owed all the money,” Hyman said. “So this big balloon payment came due at the end.”
At that point, most people just borrowed the money again for another three to five years. That worked, Hyman said, as long as banks had money to lend. But when the Great Depression hit, “people began to pull their money,” he said. “There was a financing crisis in 1932 for mortgages.” Hundreds of thousands of people suddenly faced foreclosure.
Enter the country’s new president, Franklin Delano Roosevelt. In 1933 he launched the New Deal and set off a wholesale rethinking of the way we buy homes. Congress created the Home Owners’ Loan Corporation, to buy failing mortgages and convert them into longer-term loans with payments that included interest and principal. Then came the Federal Housing Administration, which insured mortgages against default and set new standards for those loans. Hello, 15-year mortgage. “And then basically the FHA kind of keeps pushing it to 20 years, and then 25, and then 30,” said Andra Ghent, who teaches real estate finance at the University of Wisconsin-Madison.
For buyers, predictable payments over a long period of time made homeownership more affordable. But for banks, a 30-year mortgage with a fixed interest rate didn’t make a lot of sense. The interest they had to pay to depositors and to borrow money wasn’t fixed. In the 1970s Congress took care of that problem, by authorizing Fannie Mae and Freddie Mac to buy mortgages from lenders, taking the risk off their books. “So again we have some government intervention,” Ghent said. Banks figured, “’Okay, I have no problem making a 30-year loan because I know Fannie and Freddie are going to buy it,’” she said.
And that, in a nutshell, is how the 30-year mortgage became king. But should it be? For starters, said AEI’s Pinto, the 30-year mortgage pushes up home prices, by making it easier for buyers to manage a bigger loan. Those buyers end up paying a lot more interest over the life of the loan. And, he said, “the amount of principal relative to interest is very small and it takes a very long time to build up equity.”
Of course, you can still get 5-, 15-, and 20-year mortgages, if you can afford the higher monthly payments. And plenty of people still choose adjustable rates. But according to the Mortgage Bankers Association, the 30-year fixed is so ingrained in the home-buying system, it made up 88 percent of applications last month.
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