Earlier this year, the New York branch of the Federal Reserve hosted a series of panels discussing how mortgage loans of the future may be dramatically different from today's. Let's take a closer look at a few highlighted by the Fed's panelists.
Issues with the mortgage as it exists today
Before diving in, let's quickly define the two primary mortgage structures available in the U.S. today -- the fixed-rate mortgage and the variable-rate mortgage. The two are similar in that they both generally allow a borrower to repay the loans early without a "prepayment penalty", and they each have a 30-year payback period.
The difference is that a fixed-rate loan locks in the borrower's interest rate for the life of the loan, so there are no surprise payment changes five or 10 years down the road. Adjustable-rate mortgages will have changing payment amounts over time as interest rates increase or decrease. If rates rise, it benefits the borrower to have a fixed-rate loan, while a declining interest-rate environment will benefit the adjustable-rate mortgage.
Fixed-rate loans tend to come with hefty upfront fees as a way for banks to offset the costs from lost revenue if rates increase or when borrowers refinance when rates decline.
Adjustable-rate mortgages can be problematic for the borrower if interest rates rise. Higher rates will increase the loan's payment when it resets, which can be a problem for borrowers with tight cash flow or limited savings.
Research by the Federal Reserve has shown that borrowers tend to underestimate just how much interest rates can change, putting them at risk simply because most don't understand how high their payments could truly go.
There are alternative examples already from other countries around the world
The fixed-rate and adjusted-rate 30-year mortgage is the status quo in the U.S., but it isn't the only way mortgages are done around the rest of the globe.
In some countries, the mortgage market is similar to that in the United States. In the United Kingdom, for example, the basic mortgage structures are the same as in the U.S., although the U.K. has a higher ratio of adjustable-rate mortgages than in the United States.
Other countries have taken much different approaches, in a few cases going so far as to make it a crime to default on your mortgage payment. Or consider Sweden, where mortgage payments aren't required to be fully amortizing. That means when the term of your loan is complete, you may still owe a lump sum of cash and principal that wasn't included in your monthly payments.
Compared with the rest of the world, the U.S. is also unique in how much lenders rely on government guarantee programs and mortgage securitization to fund the market. The mortgage markets in other countries are effective with their own models, implying that the U.S. mortgage market doesn't necessarily have to rely on government-backed companies such as Fannie Mae or Freddie Mac to make the market work properly. Nothing is set in stone, leaving room for some interesting ideas for change.
Thinking outside the box
One idea is the "ratchet mortgage." This structure would be a specialized adjustable-rate mortgage designed so that the interest rate can only reset lower. This approach protects borrowers against rising interest rates, as a fixed-rate mortgage does, but it also allows them the benefit of a lower interest rate should rates decline. While a borrower with a fixed-rate mortgage would have to refinance a loan to get a lower rate, the "ratchet mortgage" would reset to the lower amount automatically. That eliminates the refinancing fees, avoids a new credit check, and provides for automatic savings.
Another proposal is for a "shared equity" model. Under this structure, a third-party investor would pay a down payment alongside the borrower when purchasing the home. The homeowner and investor would own the home together, which contrasts with today's "all-or-nothing" system for homeowners. For their part in the transaction, the third-party investors would get a certain percentage of the windfall when the home is sold and would accept some of the downside risk should the borrower default on the loan. This structure would increase down-payment size, reduce the debt burden on the homeowner, and reduce the risk that a home goes "underwater" if real estate prices decline.
More simply, some thought leaders question the conventional 30-year mortgage term. There's nothing magical about 30 years -- lending terms could certainly be shortened to 15, 20, or 25 years. Most other countries require shorter terms, and as a result, borrowers are able to build equity much more quickly with only a nominal increase in their monthly payment. A $200,000 loan at 4% for 30 years would have a $995 monthly payment. Decreasing the loan term to 20 years would increase the payment to just $1,212, and after five years, the 20-year loan would be paid down by $36,818, 190% more than the 30-year loan.
The reality of mortgage reform
Meaningful reform in the U.S. starts with changes to Fannie and Freddie. Under the current system, these companies dictate the terms and requirements for lenders and borrowers across the country. If they were to accept these or other innovations, that would be enough to drive a massive change in the way U.S. homeowners borrow money for their homes.
However, because of their government affiliation, any major changes in Fannie and Freddie's policies, or how the market operates is a political issue, and that makes change much more difficult. For homeowners, investors, and lenders today, that means there is no certainty about what will or won't happen, or when.
