The Thirty Year Fixed Mortgage

In yet another sign that the Great Recession is receding, earnest discussion has begun in the punditocracy on long-term cures for our nation’s home mortgage system, particularly Fannie Mae and Freddie Mac. (Remember them?)

Victorian House I’m not sure if anything at all will come of this. It’s not clear that Congress has enough gas left in the tank to finish with healthcare, never mind rewiring the mortgage business. If I had to bet money I would say that this window of opportunity, in which there is consensus that something needs fixing, will close without much of anything changing.

But it’s inspired some rare discussion of that great American institution, the thirty year fixed rate mortgage. And it really is a uniquely American institution. Except for Denmark, which has a very peculiar system dating to the Eighteenth Century, only in America do consumers think that borrowing on thirty year fixed rates is normal.

In fact, at least in the view of our elected officials, a thirty year fixed isn’t just normal, it’s a near constitutional right. Like the right to bear arms in National Parks or talk on the phone while driving.

But is it really all that great a deal to begin with? Is fixing the interest rate for thirty years really as valuable as we seem to think?

The great majority of mortgages are for 30 year terms, meaning that if the borrower makes the payments as agreed for thirty years the loan will be fully paid off. (Fifteen year terms exist, but are relatively uncommon, and other terms are rare.) Most, but not all, of those 30 year mortgages have fixed rates for the whole term.

The mortgages that have thirty year terms but not thirty year fixed rates are called adjustable rate mortgages, or ARMs. At the start of the Great Recession they got a lot of bad press, but that seems to have died down. It would be nice to think this is because we all worked out that ARMs were not really the problem, but it also possible that the media got tired of reporting on complicated mathy things and moved on to better narratives like Madoff and bailouts.

ARM is a bit of a misnomer. These mortgages are generally fixed-adjustable hybrids, with a period of fixed interest at the start and then an annually adjusting rate thereafter. So a 5/1 ARM is a mortgage that will have five fixed years followed, at least in principle, by 25 years of annually adjusting rates.

Amongst the many pieces of mortgage information I would like to have but can’t find, is the proportion of ARMs that actually get to the adjusting stage and how long they stay there. Americans move house about once every 14 years on average and refinance their mortgages more frequently than that. Personally, I’m in the process of getting my sixth 5/1 ARM. I only let one of the previous five adjust at all, and then only once.

If you are shopping for a mortgage you are presented with a menu of ARMS (3/1, 5/1, and 7/1 are popular) and the old thirty year fixed. Generally speaking, the interest rate you pay during the fixed period is inversely related to the length of that fixed period, so a 3/1 will have the lowest rate, 5/1 the next lowest, and so on until you get to the thirty year fixed, which will have the highest rate.

So that’s a tradeoff: higher interest rate while fixed in exchange for a longer period of being fixed. How should a person decide which mortgage to choose? Unavoidably, it will involve predicting the future, namely how long it is likely to be that the mortgage will run.

The first reason a mortgage might not actually be in service for thirty years is that the borrower might sell the house before then. That 14 year statistic I cited is real, but somewhat misleading. Homeowners are divided into those for whom it is nearly inconceivable that they will not move within the next ten years or so and those who, if all goes according to plan, are currently in their last house.

The short termers might include those whose careers will likely require them to change cities, those who expect to be able to afford more house in the future, and those who expect to require more or less house in the future because of a growing or shrinking family. Long-termers like me don’t expect ever to need or want to move to another house and look forward to being grumpy old men right where they are now.

The point being that most people can do a decent job of guessing how long it is likely to be before they will sell and move on.

The other reason a mortgage may not live out its full thirty year lifespan is because it gets refinanced. When interest rates are below what a homeowner is currently paying, it makes sense to refinance. How often that is likely to occur is very difficult to predict, but we’ve had several waves of refinancings over the past few decades. (Another statistic I’d like to see: how many of the 30 year mortgages written in 1980 are still with us? I’m betting practically none of them.)

All of this is background to my central question: if your best guess was that you were going to need the mortgage you were taking out today for seven years, wouldn’t you obviously prefer a 7/1 to a thirty year fixed? The thirty year does give you the peace of mind that if you wind up needing the mortgage to live longer, you know what the interest rate will be, but that reassurance comes at a steep price. If the difference between the 7/1 and the thirty year is 0.5% in interest (a reasonable figure I am pulling out of thin air) then over the first seven years the difference in cost of the two mortgages is 3.5% of the principal, and that’s real money.

Turns out, the market share of thirty year fixed mortgages is around 70%. There is no question that some of those 70% of households legitimately are better off with a thirty year, at least based on their predictions of the future. They expect interest rates to never again be as low as they are now and they expect to be in their current house for the duration.

But it is simply inconceivable that homeowners that fit that description are anything like 70% of mortgage borrowers. I wouldn’t be surprised if the number for whom a thirty year fixed is rationally the best choice were a tenth of that.

So why so many thirty year fixed mortgages? Like many such phenomena, a big driver may be ignorance. Consumers just don’t know any better and nobody is explaining this to them. Indeed, an unelaborated preference for the responsible sounding thirty year fixed is a consistent theme from personal finance experts.

The tragedy in all this is that the government spends a lot of effort and truly vast sums of money to build and maintain the infrastructure for a mortgage product that ought not to be so vital or desirable. Much of the exquisitely ornate financial machinery that got gummed up last year, causing the global meltdown, was there because of the need to deal with tens of millions of very long term consumer loans, that is, with thirty year fixed mortgages on American homes.

38 Comments

  • By Neil, December 16, 2009 @ 7:01 pm

    It is a strange mortgage product, and that such a thing would be normal. The longest fixed rate anyone in Canada will guarantee me is 10 years (and I can get any period below that, with 5 years being given preferential treatment over 4 years, but still higher than 3 years). So here, it’s normal to have a 5 year loan on an amortization schedule to pay it off between 20 and 35 years after the initial issuance. After 5 years you have to renew (and can change providers at no penalty).

    But while these are nice for their predictability, the research indicates that if you buy your home at a random time, you’ll have an 88.6% chance of coming out ahead with a truly floating rate (a rate that is based on the bank’s prime rate, not fixed for any period at all). Since the 11.4% of the time that fixed rates come out ahead is during periods of unusually low interest rates (ie. recessions), for a real-life home buyer that is more likely to buy when times are good, the odds are even better.

  • By Mr. ToughMoneyLove, December 16, 2009 @ 7:35 pm

    A factor leading to the popularity of the 30 year fixed rate mortgage is that for many years (including in my lifetime), many of these mortgages were assumable by a buyer. That made them very attractive products for even short-term owners when rates were relatively low. The assumable fixed rate mortgage has gone the way of the Dodo bird but the afterglow remains.

    In today’s market, with all of the costs of buying and selling, it doesn’t make a lot of sense for a short-timer to buy anyway.

  • By Stephen Stchur, December 16, 2009 @ 8:04 pm

    Frank,

    I was really happy to see this post because I am in the process of looking for a home now (in the Seattle area) and trying to decide what type of mortgage I should use.

    However, I was disappointed in your post in that it seemed to end abruptly and without conclusion. I’d like to see you give some more of your opinion on how one should decide which is best. I’m not afraid of complexity and I’m not afraid of math. Complications be damned. Give me something I can sink my teeth into!

  • By Paul Williams @ Provident Planning, December 16, 2009 @ 8:31 pm

    The only problem I can see with going to ARMs instead of a 30 or 15 year fixed based on your analysis is closing costs. If you have to refinance every 3, 5, or 7 years, you’d really need to pay attention to any closing costs or other loan fees as they would eat into your interest rate savings. The other problem would be renewing your loan in periods of high interest rates if you’re still in the same house.

  • By Investor Junkie, December 16, 2009 @ 8:46 pm

    Hi Frank,

    At least in today’s market why NOT get a 30 year fixed? If the rate is sub 5% and after tax deduction (assuming housing stays deductable) your real rate is in the 3-4% range. Why not??

    In your case, you are suggesting rates will stay this low 5 years from now? If I were a betting man I would have to say rates would be at higher, especially with the amount our government has help push down rates.

  • By Stephanie RJ, December 16, 2009 @ 8:49 pm

    Did you notice that ING is offering a 5 year fixed balloon mortgage? At a 3.764% APR? Assuming closing costs are not astronomical, it makes a 5/1 ARM look like an expensive way to ensure that if you forget all about refi-ing at the end of 5 years, you’ll only end up with a variable payment and not a bill for the balance of your mortgage…

  • By Abby, December 17, 2009 @ 10:36 am

    You’re a rock star, Frank Curmudgeon.

    This topic led to a BRAWL at Thanksgiving dinner a few years ago, when my husband I were buying our first house. We knew we wouldn’t be there for more than five years, and we knew the ARM was WAY cheaper. (We were there for four years, one month.)

    This is just one of those sacred cows of American financial planning.

  • By Dan, December 17, 2009 @ 11:43 am

    How does an ARM work when it adjusts? What rate does it adjust to?

  • By Evan, December 17, 2009 @ 12:43 pm

    “But it’s inspired some rare discussion of that great American institution, the thirty year fixed rate mortgage. And it really is a uniquely American institution”

    What is the norm in other Countries ?

  • By Larry, December 17, 2009 @ 1:04 pm

    Dan: “How does an ARM work when it adjusts? What rate does it adjust to?”

    Depends on your ARM, I would imagine. FWIW, when I bought my coop apartment 20 years ago, the complex was converting from all-rental to part-owner, and the banks would not write fixed-rate mortgages because not enough units had been sold. My ARM is tied to the 1-year treasury, and can go up or down no more than 2% annual, with a lifetime cap of 14%. Given interest rates for the past 10-15 years, I totally lucked out.

  • By Ivy, December 17, 2009 @ 1:30 pm

    I too would like some analysis of of the numbers… even though they don’t apply to us.

    We just purchased a home after a period of three years where we rented (and moved a couple of times). That means that we qualified for a first time homebuyer loan (again) and the tax credit. 30-year fixed at 5% and an ASSUMABLE mortgage (yes, Virginia that mythical creature still exists). We plan on being in the home forever (AKA until our daughter graduates from high school — 12 years). But how could we beat those rates buying at the bottom of the interest curve and knowing we’re staying put? And if interest rates shot up and we did need to sell, the new buying could take advantage of our low rate.

    So it can work, but I have to admit it’s under unusual circumstances.

  • By Stephanie RJ, December 17, 2009 @ 2:19 pm

    Evan, in NZ where I’m from you get a term mortgage for usually 1-5 years at a time, which you can choose to have either fixed or floating. It’s prohibitively expensive to refi out during term, usually – you end up paying more or less the balance of interest owing. It’s also rare (though not nonexistent) to be able to pay down the balance during the term of the mortgage; instead, you’d save up and make lump sum payments at the end of a term if you wanted to pay it down faster.

    If the interest rates were high trending down you might go for a 1 year floating; if high trending up you might choose a 1 year fixed for predictability; if they were historically low (which they are right now at a mere 6.x%) you might fix for 5 years.

  • By Jim, December 18, 2009 @ 7:20 pm

    “Another statistic I’d like to see: how many of the 30 year mortgages written in 1980 are still with us? I’m betting practically none of them.”

    Very hard to find. Best I can come up with data that would give an approximate idea…

    Between a couple different census reports I would figure that around 6% of the primary mortgages originated in 1980 are still on the books.

    In a 1985 statistical abstract it says that 5.9M mortgages were originated in the years 1979-1981, thats 1.96M per year. Then in more recent data as of 2007 it said that 626K mortgages originated in 1980-1984 were still outstanding or roughly 125k per year. So if we approximate it with the (bad) assumption that mortgage #’s are evenly distributed through those 3-4 year periods then that means about 1.9M mortgages were filed in 1980 and about 125k of them are still being paid on. Thats about 6.4%.

    Now this doesn’t differentiate between 30 year mortgages and mortgages of shorter periods but the vast majority of mortgages were 30 year ones.

  • By Jim, December 18, 2009 @ 7:21 pm

    Sources for above:
    2007 mortgage info:
    http://www.census.gov/hhes/www/housing/ahs/ahs07/ahs07.html
    1985 data on page 113:
    http://www2.census.gov/prod2/statcomp/documents/1985-08.pdf

  • By Jim, December 18, 2009 @ 7:33 pm

    Heres another bit of data:

    As of 1999 there were over 21M mortgages originated from 1995 to 1999. By 2007 only about 6M of those mortgages still existed. So over 70% of the mortgages started in the late 90′s didn’t last the 8-12 years till ’07.

  • By a, December 24, 2009 @ 5:32 am

    “When my husband I were buying our first house. We knew we wouldn’t be there for more than five years, and we knew the ARM was WAY cheaper. (We were there for four years, one month.)

    This is just one of those sacred cows of American financial planning.”

    Or maybe the sacred cow you’re thinking of is: buy rather than rent? Those who know they’re not going to be in a house more than five years should be renting rather than buying.

  • By Cotton, March 29, 2010 @ 4:43 pm

    Well, I am in the process of refinancing my mortgage from a 30 yr fixed 6.5%; BOA who I’m currently with will give me 5.25 30 yr fixed which will lower my monthly payment by about 175 bucks a month; I am also looking at a hybrid ARM 5/1 which starts at 3.5% for 5 years, adjusts to 5.5 in the 6th year, 7.5 the next and caps at 8.5 for the life of the loan. It will make the initial payments around 275 dollars lower/month. I am hoping to use the savings to add that back to principle every month to pay down the loan; one of the advantages of the ARM is that it re-amortizes with each interest change so that you’re paying on less principle. But I’ve always had a 30 yr fixed so don’t know if this is too risky. Thoughts?

  • By dizzyfingers, August 15, 2010 @ 10:52 am

    30 year fixed allowed us a lower rate than anything else. We always lived below our means, paid our monthly payment, and finally paid off our mortgage. That simply used to be the way it was. Now, with jobs less reliable over time, perhaps some still can make sense of a 30 year fixed but some can’t. 30-Y-F used to have no penalty for early pay-off (as in cases of sale of the home) and some but very few were assumable. Why does it have to be 30-Y-F or nothing? Isn’t there room for different types that suit different peoples’ needs?

  • By David Wendelken, August 24, 2010 @ 2:59 pm

    If the market value of the house goes down below what you owe on it, you can’t refinance it at a lower rate when the ARM resets.

    And just because you intend to move doesn’t mean that you’ll find a buyer at a price you want when you want one.

  • By Offset Mortgages, October 25, 2010 @ 12:02 am

    hi i m william martin i want to tell you just that in today’s market, with all of the costs of buying and selling, it doesn’t make a lot of sense for a short-timer to buy anyway.
    Offset Mortgages

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  • By Brenda, March 3, 2012 @ 3:01 pm

    I know many people who were talked into bad arms, subprime loans and since are struggling to keep their house or have already lost it and were ripped off real bad.

    I was fortunate that I took advantage of a home buying nonprofit service thru my workplace that guided me thru the process and I got a fair, fixed rate loan.

    I believe if America’s homeowners had fair, fixed rate 15 or 30 year mortgages, the foreclosure crisis wouldn’t have happened. It’s because the average person doesn’t know anything about finances and trusts the wrong people that the financial meltdown happened.

    If American homeowners would rely on credit unions or small local banks instead of brokers and the big banks and if they had been steered to fixed rate 15 or 30 year loans, we wouldn’t be in the mess we are in today!

    But as heartbreaking as a foreclosure is, at least they can walk away. You have thru 2012 to not have to pay the govt back taxes on a short sale or foreclosure.

    However, student loan debt never goes away. Too many people find out that the hard way, even when they retire or are on SSI, the govt is now garnishing social security and disablity 15% if they incurred or co-signed for student loans even decades earlier.

    Please bring up the terrible situation of student loans. President Obama’s income based repayment only applies to govt loans and those going forward, all the rest of people with either private loans or older loans are out of luck!

  • By Brenda, March 3, 2012 @ 3:10 pm

    One person I know was steered into a 2/1 ARM when rates were around 5% for a fixed 30 year. She was paying 8% for the 2/1 ARM and then it reset to over 9% and she found she couldn’t refinance due to her credit, bills, and the dropping value of the house. The broker that sold her that crappy mortgage told her to sell the house. Good luck with that when you owe more than the house is worth. She eventually got some adjustment from Wells Fargo, but it wasn’t easy or ideal.

    If she had gone thru a credit union and gotten a fair, fixed rate of 5% 30 year, none of this would have happened. But she listened to a slick broker promising her pie in the sky. I’ll get you the house you want, and then you can refi in 2 years to a better loan. It was a terrible deal all the way around, but she had fallen in love with the house and her credit wasn’t the best.

    I remember always being told one should go to a broker because they had a great selection of loans to choose from, didn’t ever mention anything about the YSP ie a secret kickback to the broker for selling a higher interest rate to the sucker. Many people were pushed into subprime loans, even if they would have qualified for prime loans to pad the profits of the banks and brokers. If these people had stuck with a non-profit credit union, none of this would have happened!

  • By Brenda, March 3, 2012 @ 3:18 pm

    Also if you had 5/1 or 7/1 because you were going to sell, you could still get stung if things didn’t work out the way you planned. I’m sure there are people out there who found themselves unable to sell their home or refinance after the housing bubble collapsed and if they had a fair fixed rate 15 or 30 year mortgage they’d be in much better shape. Just saying!

  • By John, February 1, 2013 @ 11:31 am

    This article is very useful. I am also a member of the mortgage community and have had the priviledge of building one of the most successful companies in the industry. The 30 year fixed is the most popular loan program in America; however it comes at a steep price. Most financial experts will tell you that the 30 year fixed is a very expensive and in most cases, an unsuitable loan program for the majority of homeowners.

    During the application process request that the loan officer put together a cost matrix and suitability analysis to outline the most advantageous and beneficial fixed duration program to meet your financial needs. This analysis should define for you the implied safety premium you pay for 30 year duration versus shorter duration. Also have them apply that duration premium towards principal accelertation to compare loan balances and interest savings at end of each duration term.

    The industry’s dirty little secret is to entice homeowners into 30 year fixed rate mortgages knowing very well that the homeowner will not carry the loan to term. They earn huge profits on increased execution of the longer duration while statistics show that they will only have to service that 30 year paper for an average of 3-5 years.

    This is a huge profit center for the lender and a costly financial choice for the homeowner for the implied safety of 30 year fixed duration that they will most likely never exercise.

    Interim Fixed Duration’s of 5,7 or 10 years are more suitable in most cases. Be sure to work with an experienced financial expert. Independent Mortgage Brokers tend to be well versed in structured finance versus call center staff at large banking institutions. I hope this food for thought has helped.

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