The voices of Urban Institute's researchers and staff
November 13, 2014

The 15-year mortgage is not a silver bullet for low-income borrowers

The 30-year fixed rate mortgage is America’s most popular mortgage product and the foundation of today’s mortgage market. The lower monthly payment makes the loan affordable to lower and middle income borrowers. But most of the payments made in the early years of a 30-year mortgage only pay off interest, making it hard for borrowers to build equity in their home during those years.  Earlier this year, we wrote about the superior equity-building and performance qualities of a traditional 15-year fixed rate mortgage.  We noted, however, that the higher monthly payments on that loan would limit its appeal.

Over the last few months, others have opened up a discussion about the Wealth Building Home Loan (WBHL), a new 15-year mortgage product. While the precise parameters of the WBHL are not always clear, the basic idea is that money a borrower might otherwise have used for a down payment would be used to buy down the interest rate on the 15-year mortgage, thus reducing the monthly payment.  The lower interest rate on the shorter-term mortgage would also enable equity to build—albeit from a zero base—more quickly than with a 30-year mortgage.

At least some proponents of the WBHL view it as a potential substitute for the FHA-insured 30-year mortgage, trading an up-front government subsidy to buy down the interest rate for the longer term risk they perceive is presented by FHA-guaranteed loans. We discuss below, however, why the 15-year mortgage, even in the WBHL form, is unlikely to be a viable option for most low-income borrowers.

Rates needed to make payments on shorter-term products equivalent to the 30-year fixed: Suppose that a borrower buys a house for $200,000. The fixed 30-year interest rate is 4.19 percent (October 2014’s standard Freddie Mac rate). With a 20 percent down payment (a loan to value ratio (LTV) of 80) on a $200,000 loan, the monthly payment would be about $780. With no down payment, the monthly payment would be $977. (We will ignore the mortgage insurance payment that must be made for GSE loans with LTVs over 80 and FHA mortgages.)

15yr

The table* shows what the interest rate would need to be for the monthly payment to stay at $977 for a variety of mortgage products with shorter amortization periods.

To equal the $977 monthly payment of the 30-year fixed rate mortgage, an 18-year fixed rate loan would need to have an interest rate of 0.6 percent and a 20-year loan would need a rate of 1.63 percent. A 15-year loan with a 22-year amortization and a balloon payment at maturity would require a rate of 2.41 percent.

The most recent actual rate on the 15-year fixed rate mortgage from Freddie Mac was 3.27 percent. Even if the interest rate were reduced to zero, the payment on the fixed 15-year mortgage would be more than $1000 per month. Indeed, the shortest period a lender can choose that will fully amortize the loan is 18 years.

The interest rates needed to make the non-standard products equivalent are well below market rates. From the table we can easily see that there is huge difference between market mortgage rates and our hypothetical rates. For example, compare the fixed 15-year mortgage rate of 3.27 percent to the hypothetical rate for the fixed 18-year mortgage of 0.6 percent, roughly a 2.7 percentage point gap – making this a below-market product with limited appeal to lenders.

Buying down the interest rates still won’t close the gap enough. A possible way to close the gap and bring these products closer to market rates while maintaining the lower monthly payment is to use the borrower’s down payment to buy down the interest rate, as proposed in the WBHL. For example, instead of making a 5 percent down payment, the borrower uses $10,000 (5 percent of $200,000) to buy down the interest rate on the loan. Traditionally, a payment equal to 1 percent of the mortgage (one “point”) will buy down the interest rate by one-quarter of 1 percent of the interest rate (0.25 percent). If the borrower buys five points using the 5 percent down payment, this yields a 1.25 percentage point decrease in the interest rate -- still far short of the 2.7 percentage point gap. And most lenders limit buy-downs to 3 points.

Non-standard products have unique liquidity and credit risks. Even if a lender were willing to subsidize the interest rate up front to fill the gap between the standard interest rate on a 15-year (or 18-year) loan and the lower rate needed to match the payment on a 30-year fixed rate loan, there is another risk the lender faces: liquidity risk. Except for the fixed 20-year mortgage, the other products discussed, including the fixed 18-year mortgage, are not standard products in the mortgage-backed securities market.  Combined with the lack of mortgage insurance, this would make it very difficult for an originator of one of these shorter-term low-interest rate loans to sell the loan into the secondary market, increasing the lender’s liquidity and credit risk—and potentially the subsidy needed to support the product.

These loans offer little lender protection in the early, riskiest years of the loan. What about the faster equity buildup and its impact on loan performance?  We agree that a shorter amortization period would significantly decrease the likelihood and severity of borrower default.  With no equity to start with (since the down payment has been used instead to buy down the interest rate), equity does not reach 20 percent until the end of year three for an 18-year loan or year 4 for a 20-year loan.  This is significantly earlier than for a 30-year loan, which, starting from zero equity, takes 10 years to reach 20 percent equity, but it does little additional to protect the lender during the critical first three years of a loan. In fact, a zero down loan with no mortgage insurance initially provides less protection to the lender than a 3.5 percent down loan with mortgage insurance.

Fifteen-year mortgages are a good option for some but no magic bullet for low income borrowers. As we said in January, the 15-year fixed rate loan is a good option for borrowers who can afford the higher monthly payments. But driving the payments down to levels that most low-income borrowers can afford requires a significant interest rate subsidy, even if a down payment is used to buy down the interest rate.  And the resulting loan would almost certainly need to be retained in a lender’s portfolio.  Simply put, there is no free lunch. It is very hard to combine a low monthly payment with a short amortization period without a huge subsidy and, notwithstanding faster equity build-up, potentially higher risk for the lender.

*An earlier version of this table included the actual, not hypothetical, rate of 15-year fixed rate mortgage.

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Comments

Years ago, a so-called Growing Equity Mortgage or GEM was offered by a few lenders. GEMs started with the same monthly payments as a 30-year fixed rate mortgage. Each year, the loan payments increased slightly (2% or 3%, I think) . These increased payments accelerated the loan so that the principal would pay off in 19 or 20 years as I remember. The borrower still had equity at the start of the loan and I think the rates were slightly lower because the loan term was shorter.

A more popular loan was Graduated Payment Mortgage or GPMs. GPMs were 30-year fixed rate mortgages that started with a lower payment that increased each year for 5 or 10 years and then were flat. Some GPMs had initial payments that were lower than the interest charged, so they had negative amortization. Even with negative amortization, borrowers had more equity than if their normal down payment was used for a rate buy down instead. FHA even offered GPMs, so the loans could be sold on the secondary market.

Perhaps we should be looking at these models again for the future.

In response to Jerry: We need to be thinking through multiple alternatives to where we are today, including not only variations on standard mortgages but also other structures, including forms of shared equity. Thanks very much for reminding us that there are older ideas we should consider again as we move into a world in which borrowers may have quite different income and wealth characteristics than are reflected in standard underwriting and products.