Are Fixed-Rate Mortgages the Best Loan?

The think-tank Center for American Progress is questioning the premise that a 30-year, fixed-rate mortgage is the best option for homebuyers.

The reason mortgage-backed securities looked so attractive to banks is that they solved the problem of a mismatch between low rates on mortgages and higher rates for deposits. Banks worried about getting stuck earning low rates on a mortgage for 30 years while having to pay higher rates on bank accounts to attract depositors. Their answer: unload their mortgages to investors and let them worry about the profitability of the loans. Those investors hedged their bets by purchasing interest-rate swaps and other derivatives. Now, even Fannie Mae and Freddie Mac are having a hard time getting a handle on what those hedges are worth.

In other parts of the world, variable rates are the norm. While borrowers face the risk of rates going up, lenders at least can ensure the rates they pay to depositors don’t outstrip what they receive in mortgage products. Homeownership rates in Canada and the European Union, where variable rate mortgages are the norm, are about what they are in the U.S.

And in any case, there are ways for borrowers to mitigate their interest-rate risk. They can take out loans with fixed initial period, for example. For homeowners who typically hold their homes for seven years, a five-year fixed rate provides considerable security.

If the country persists in choosing fixed-rate mortgages, some observers say, lenders might consider the Danish model where mortgages are financed through the bond market rather than a separate securities market. That’s a system that has worked well for two centuries.

Source: The Wall Street Journal, James R. Hagerty (12/14/2009)

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