In the U.S., there may be no more important financial product than the 30-year fixed-rate mortgage. Americans hold $10.3 trillion in mortgage debt, according to the Urban Institute, and over 70% of all mortgages are of the 30-year fixed variety. With the housing-fueled 2007-09 recession in our rearview mirror, it’s worth asking whether the U.S.’s appetite for fixed-rate mortgages is healthy.
Borrowers typically view adjustable-rate mortgages as risky products. ARMs generally offer borrowers a fixed interest rate for a set period, often lower than the rate on a fixed-rate mortgage, followed by adjustable payments that vary with economywide rates.
The popular perception seems to be that ARMs allow homeowners to trade off a few years of lower interest payments for the risk of seeing a mortgage interest payment rise. But to economists, it isn’t so simple.
It’s true that fixed-rate mortgages come with a constant payment. But it isn’t quite right to simply classify ARMs as riskier for one simple reason: Interest rates tend to rise when the economy is doing well and typically fall when the economy is doing poorly. Rather than seeing adjustable interest as a risk, homeowners should see it as protection against a downturn in the economy.
If economic growth stalls, the Federal Reserve cuts rates and homeowners get a break. If growth picks up, the Fed raises rates and homeowners pay more—but chances are they can afford a higher payment. From this perspective, fixed-rate mortgages are actually the riskier products because they don’t offer relief if homeowners are facing a sluggish economy.
It’s true that homeowners with fixed-rate mortgages can always manage risk through refinancing, which allows borrowers to swap out a loan for one with a lower interest rate. But it’s expensive, costing over 1% of the mortgage value for the privilege. Even worse, refinancing can be unavailable in downturns due to either negative equity or other disqualifications.
With fixed-rate mortgages, think of refinancing as an insurance benefit that can be claimed if things get bad, but not too bad. ARMs, by contrast, automatically adjust when the economy stumbles and interest rates fall—there is no need to refinance, and borrowers save on expensive fees.
While policy makers nationwide have probably not done enough to prevent the next housing crisis, a subset of economists have been thinking through how to design mortgages to make homeowners better off.
One paper, by economists Janice Eberly of Northwestern University and Arvind Krishnamurthy of Stanford University, found that allowing borrowers a guaranteed option to convert their fixed-rate mortgage into an ARM, even if underwater, would go a long way toward stabilizing the housing market. The authors’ central observation was that this type of contract would prevent foreclosures by lowering monthly payments in a downturn, while also discouraging strategic default by reducing the total amount owed for the life of the loan.
Similarly, a recent working paper by Adam Guren of Boston University, Prof. Krishnamurthy, and Timothy McQuade, also of Stanford University, found that this costless option to convert to an ARM would have substantial benefits on stability and well-being over the course of a financial crisis. Others have pointed out that, during a recession, ARMs can help the Federal Reserve speed up a recovery by transmitting lower interest rates into lower interest payments for consumers.
It’s time to rethink whether ARMs are riskier than fixed-rate mortgages. After all, the inability to take advantage of lower interest rates is a form of risk. This isn’t to say that ARMs are right for everyone; certainly not for those who will struggle to make payments should rates rise. But allowing mortgages rates to change with the economy can yield better outcomes for both consumers and the economy on the whole.