Improving the 30-Year Fixed-Rate Mortgage

77 Pages Posted: 7 Sep 2017

See all articles by Wayne Passmore

Wayne Passmore

Board of Governors of the Federal Reserve System

Alexander von Hafften

Board of Governors of the Federal Reserve System

Date Written: 2017-08-25

Abstract

The 30-year fixed-rate fully amortizing mortgage (or "traditional fixed-rate mortgage") was a substantial innovation when first developed during the Great Depression. However, it has three major flaws. First, because homeowner equity accumulates slowly during the first decade, homeowners are essentially renting their homes from lenders. With so little equity accumulation, many lenders require large down payments. Second, in each monthly mortgage payment, homeowners substantially compensate capital markets investors for the ability to prepay. The homeowner might have better uses for this money. Third, refinancing mortgages is often very costly. We propose a new fixed-rate mortgage, called the Fixed-Payment-COFI mortgage (or "Fixed-COFI mortgage"), that resolves these three flaws. This mortgage has fixed monthly payments equal to payments for traditional fixed-rate mortgages and no down payment. Also, unlike traditional fixed-rate mortgages, Fixed-COFI mortgages do not bundle mortgage financing with compensation paid to capital markets investors for bearing prepayment risks; instead, this money is directed toward purchasing the home. The Fixed-COFI mortgage exploits the often-present prepayment-risk wedge between the fixed-rate mortgage rate and the estimated cost of funds index (COFI) mortgage rate. Committing to a savings program based on the difference between fixed-rate mortgage payments and payments based on COFI plus a margin, the homeowner uses this wedge to accumulate home equity quickly. In addition, the Fixed-COFI mortgage is a highly profitable asset for many mortgage lenders. Fixed-COFI mortgages may help some renters gain access to homeownership. These renters may be, for example, paying rents as high as comparable mortgage payments in high-cost metropolitan areas but do not have enough savings for a down payment. The Fixed-COFI mortgage may help such renters, among others, purchase homes.

Keywords: COFI, Cost of funds, Financial institutions, Fixed-rate mortgage, Homeownership, Interest rates, Mortgages and credit

JEL Classification: G21, G28, G41, R31, R38

Suggested Citation

Passmore, Wayne and von Hafften, Alexander, Improving the 30-Year Fixed-Rate Mortgage (2017-08-25). FEDS Working Paper No. 2017-090. Available at SSRN: https://ssrn.com/abstract=3029740 or http://dx.doi.org/10.17016/FEDS.2017.090

Wayne Passmore (Contact Author)

Board of Governors of the Federal Reserve System

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Alexander Von Hafften

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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