Back to the future.
THE MORE THINGS CHANGE, THE MORE THEY STAY the same. Or in the cyclical world of real estate and mortgage rates, if it was a good idea once, it might be a better idea again.
What we're seeing in the market currently is renewed interest in a type of financing that was popular back when hula hoops were all the rage. Although the reasons may be different, a new group of borrowers is asking for the very same loans used to finance the homes they grew up in.
Contributing to the popularity of these mortgages is the still-booming refinance market--now 18 months old. Except for one week in 1992, average interest rates for 30-year mortgages have been below 9 percent since September 1991. In early April, the 30-year mortgage rate was closer to 7 1/2 percent. And these low rates have spurred savvy consumers to lower their mortgage costs and reduce their debt.
As rates descended, the volume of 15-year mortgages soared. And now the 20-year mortgage has been discovered by sharp 30- and 40-somethings who are eyeing the approach of colliding college tuition costs for their offspring and the funding demands of their own retirement. As a result, the dominant mortgage of the 1960s--the 20-year mortgage that served this generation's parents so well--has returned.
A look back
Back in the 1960s, homeowners actually planned on owning their home outright. For the most part, they also expected to live in the same house for the duration of their mortgage. Mortgage rates were around 6 percent. A single-family home was detached, with a yard and a driveway, and the average price was less than $25,000. Usually, one income qualified the borrower for financing.
By the 1970s, the "town" house out in the suburbs was becoming common, as double-digit inflation changed the face of housing. From 1972 to 1975, the cost of a new single-family home rose from $27,600 to $39,200. Authors Sarah K. Crim and Susan Cirillo wrote in the May 1976 issue of Mortgage Banker, "Now it very often takes the combined income of husband and wife to qualify for a mortgage loan on a house, whereas only 10 years ago, the wife's income would not be counted unless her occupation had professional status."
The 30-year mortgage was born in this environment--out of necessity. Borrowers could often qualify only if their payments were stretched out over a longer period of time, much like the way that payment terms were extended on automobiles from two years to four and five years. But while the 30-year mortgage helped more families become homeowners in the early to mid-1970s--the homeownership rate actually hit 75 percent in 1974--it couldn't begin to help those in the 1980s housing market.
Creative financing arrives
By December 1979, the 30-year interest rate was approaching 13 percent. And, by October 1981, it peaked at almost 18 1/2 percent. Creative financing was needed for the housing market's survival. And the adjustable-rate mortgage (ARM) opened the door for many homebuyers during these years. The annual average interest rate for a one-year ARM in 1984 was 11.49 percent versus the annual average of 13.87 for a 30-year fixed-rate that same year. The difference meant an estimated 61 percent of those entering the market that year favored the ARM.
Fortunately, lower rates and sanity returned to the market. The "ARM of the week" phenomenon faded, and the 30-year mortgage regained its popularity. But, transient baby boomers had discovered that mortgages like ARMs, which offered low costs during the fairly short time they planned to be in the house, were a smart deal. This same thinking fueled the 1989 introduction of the hybrid balloon mortgage. This loan provides a fixed-rate for the five or seven years the borrower plans to live in the home and allows the borrower to repay the remaining principal, or reset the interest rate and extend the mortgage when the loan matures.
The 20-year reemerges
Times have changed a bit, and we're not changing houses quite so often now. Paying off the mortgage is starting to sound like a good idea again. So, for more and more baby boomers, 15-year and, increasingly, 20-year mortgages seem to make a lot of sense when refinancing or buying a home.
Freddie Mac wanted to find out to what degree borrowers were choosing the intermediate-term product, so we asked our customers. According to a survey we conducted last summer, we learned that:
* Nearly 70 percent of our customers, big and small, were originating 20-year mortgages. In the Northeast, the numbers were even higher. Ninety percent of the Northeast lenders we polled said they originated 20-year loans. North Central lenders were also active originators of 20-year loans. The numbers decreased as you moved south and west.
* Mortgage bankers and commercial banks tended to originate 20-year products more than savings and loans.
* For 53 percent of the lenders who said they were originating 20-year mortgages, this production represented at least 5 percent of their total originations. However, there were strong regional differences. The 20-year product's share of originations ranged from 8 percent for those polled in the North Central region to 1/2 percent in the West.
* More than half the lenders viewed the 20-year mortgage primarily as a refinance loan, while 20 percent viewed it primarily as a purchase loan. And 25 percent said the 20-year mortgage was used for refinances and purchases equally.
* Lenders told us that borrowers typically selected the 20-year mortgage because they wanted to pay off the loan more quickly and they wanted to pay less interest. The 20-year loan was the shortest term the customer could afford.
* Forty-six percent of the lenders said the 20-year borrower differed from the 30-year borrower. They tended to have higher incomes, were older with more money or net worth and had more established credit. Lenders used "sophisticated," "more affluent" and "having strong, more stable credit" to describe these particular shorter-term borrowers.
* Vouching for their sophistication, 20-year borrowers usually requested that mortgage product themselves. They weren't responding to any special lender promotions for it. Apparently, they discovered the mortgage product on their own, knowing what their financing objectives were and looking for a mortgage to match.
* Lenders also told us they were selling their 20-year mortgages for cash and pooling them in securities. Some lenders had enough volume to create 20-year mortgage pools, but the majority were selling 20-year and 30-year loans together--despite the fact that investors were willing to pay a higher price for the 20-year maturity.
From these survey results, the demand for 20-year mortgages was evident. The need for a sales outlet for these mortgages was clear. So, Freddie Mac developed a special program offering a higher price for the unique term of these mortgages.
Freddie Mac responded to changing housing market conditions and the renewed 20-year mortgage trend by introducing a 20-year program in the winter of 1992. Last year, Freddie Mac was the first to buy 20-year mortgages through all three purchase programs. This allows lenders to swap one or more loans at a time for securities through the Guarantor or Multilender programs and to sell the mortgages for cash through the Gold Cash program.
Through the new pricing program, lenders receive a better price for 20-year loans, because Freddie Mac and Gold PC investors generally pay more as the term decreases. Lenders simply identify their loans as 20-year product when taking out a commitment under the Gold Cash, Multilender or Guarantor Swap programs. When swapping, lenders need to request the special prefixes of D9, F8 or F9, which identify 20-year-backed PCs.
A product with a future
With interest rates still at record lows and refinances still around 50 percent of the market in early spring, the demand for 20-year mortgages remains strong. We also believe the 20-year mortgage has a growing place in the new origination business. Tracking our past purchases of these mortgages, we learned that they roughly mirror our overall business. This means that 20-year mortgages have done well as a refinance product. However, they have also done well as a purchase product.
Borrowers have become more sophisticated about selecting the mortgage type that meets their home financing preferences. For much of 1992, 15-year loans represented about one-third of Freddie Mac's purchases. Balloon/reset mortgages were about 15 percent of Freddie Mac's purchases, and ARMs commanded 9 percent to 10 percent.
Because of the volume of mortgages that Freddie Mac buys, we have information on refinances that matches loans previously purchased by Freddie Mac. Analyzing this data yields a wealth of information about borrower motivations. Many borrowers opt to shorten their mortgage term, while many others opt to lower their monthly payments. And some borrowers also have the ability to lower their loan amount based on the amortization that has occurred since the loan was originated. For example, 47 percent of all borrowers refinanced into the shorter-term 15-year mortgage. Fifty-four percent lowered their monthly payments. And 39 percent lowered their loan amount.
The 20-year loan fits neatly into this refi picture, allowing borrowers to choose a shorter term, a smaller loan based on amortization and, frequently, a lower monthly payment. And, purchasers of new homes enjoy shorter terms and monthly payments closer to those on 30-year loans than on 15-year loans. All 20-year borrowers benefit from the certainty of interest costs and faster equity buildup. And, in a time of economic uncertainty, lower inflation and competing demands for household disposable income, paying off the mortgage affordably but sooner is more important than ever.
20-year mortgage advantages
Since we polled some of our customers last summer, the 20-year mortgage market has changed. Some lenders said more recently that they are just beginning to price the 20-year product separately from their 30-year business. Others are comparing 20- and 30-year rates in advertising and seeing their 20-year business blossom. Several seem to believe the 20-year mortgage is an outgrowth of the refi boom and will go away once rates rise. But most agree that the product is worthy of attention for the short term.
We view the 20-year mortgage as a quality product that attracts quality borrowers. The 20-year borrower typically has a higher income and a well-established credit history. And the borrower's ability to build up equity faster translates into lower credit risk.
What lenders think
Kraig Burnham, executive vice president, Homeowners Assistance Corporation in New Hampshire, recognizes this. He says, "Twenty-year customers are some of our best borrowers. They have excellent credit quality, are conservative credit users and typically have low loan-to-value ratios."
Burnham has seen his 20-year business "increase from being virtually nonexistent a few years ago to 5 percent of our business currently."
But Burnham is one of those who believe the product will lose its popularity once higher rates return. "It's almost all refi business. That's what its niche is. Its niche is not in a high-rate environment. It's for homeowners who want to reduce or retain their current payment and lower their term. We expect to see activity at least through the end of the year. It will almost disappear when rates go up. It appears to be a short-term product."
Margaretten & Company, Inc., Executive Vice President Walter Buczynski concurred, saying, "Twenty-year volume is picking up with the recent refi February market. January was slow. In February, the refi market kicked in. Currently |in mid-March~, refis are approximately 50 percent of our business."
At Margaretten, headquartered in Perth Amboy, New Jersey, the 20-year mortgage in mid-March was priced one-quarter point better in price discounts. And it has been as much as five-eighths better, according to Buczynski.
"Twenty-year business is very attractive. The 20-year has advantages over the 30. Pricing is a benefit we're promoting through fliers |distributed to borrowers and Realtors~. Our loan officers are aware of the savings over the life of the loan and pass that on to borrowers," says Buczynski.
One of the most visible lenders in the 20-year business has been Norwest Mortgage, Inc., Des Moines, which has lending offices in 49 states. Norwest was among the first to notice the spread between 20-year and 30-year loans and to promote the 20-year separately. Playing off the 20-year lows in interest rates as well as the shorter term of this product, Norwest has dubbed the 20-year loan "the Norwest Roaring 20" in fliers it gives to Realtors and builders.
At the height of the refinance boom in January 1992, the 20-year loan accounted for 5 percent of Norwest's conforming originations, according to Dave Boberg, Norwest vice president of secondary marketing.
By March 1993, it was "closer to 4 1/2 percent of our conforming business," says Boberg. "The spread between the 20- and 30-year has narrowed, so we haven't seen as many 20-years during this year's refi market."
Andrew Poisson is director of corporate development with Heartwell Mortgage Corporation in Grand Rapids, Michigan, where refis by mid-March were approximately 40 percent of the business. Poisson has high expectations for the 20-year mortgage.
"The 20-year product was 11 percent of our business in 1992, and this year our goal is to increase the business to 16 percent. The climate for the 20-year remains perfect. There are almost as many loans in the 9 percent and 10 percent range that can be refinanced as there were last year," says Poisson.
Borrowers like the 20-year mortgage because they receive lower interest rates and/or points and pay down principal faster with a mortgage amortized over a shorter period of time. And the 20-year mortgage offers the advantage of a shorter term than the 30-year mortgage, with more affordable monthly payments than the 15-year mortgage. This means borrowers can build up more equity by the time they sell their homes. With lower rates of property appreciation, this source of equity is more important than ever.
As Burnham at Homeowners Assistance Corporation says, "The cost benefit to the customer is a more attractive rate than the 30-year product. People in New Hampshire and the Northeast are reasonably conservative by nature. Unlike other parts of the country where people may just be looking to lower their payment, they're also concerned with eliminating debt. They're not usually concerned with their after-tax position."
Faster principal repayment also can mean paying off the mortgage or significantly reducing debt by retirement. One lender, for example, is promoting the product directly to this market. Prosperity Mortgage Corporation, a Fairfax, Virginia subsidiary of the Long & Foster Companies, Inc., calls its 20-year program the "Pay It Off by Retirement" mortgage or the "Baby Boomer Retirement" mortgage.
Heartwell's Poisson elaborates on this borrower motivation, describing the 20-year borrower as "a more sophisticated buyer. They've purchased up to the home they'll be in for awhile--until their kids are out of school and ready for college or thereabouts. They may have even been advised by a financial counselor to check out the 20-year mortgage."
And, the 20-year perfectly matches the needs of this age group of borrowers. "The equity will be built up just at the time these families become empty-nesters," Poisson says.
While Heartwell Mortgage doesn't do any product advertising, Poisson says it has two in-house refi specialists who are trained to offer the 20-year option to customers.
"The interest savings, combined with accessible monthly payments, is probably the single strongest selling point of the 20-year loan," says Terrance G. Hodel, president and chief operating officer of North American Mortgage Company, the nation's sixth largest originator of home loans in 1992. North American is headquartered in Santa Rosa, California. "Since we began offering it last November, we've seen a steady increase in demand for this loan," he adds.
A need to know
The way North American Mortgage sees it, the only reason it hasn't done more 20-year business is because more borrowers need to be made aware of this alternative--a theory that is supported by at least one borrower's experience.
"We were told about a lot of different loan packages, but none of them worked for us," says Linda Mellgren of Washington, D.C. "We kept pushing for a loan with a shorter term and payments that we could afford so we could pay off our home by retirement. With luck and timing, we finally found one. Mostly timing, I guess. North American Mortgage Company had just come out with its 20-year loan."
Lenders all agree that the baby-boom borrower is the reason for the recent 20-year mortgage phenomenon.
"There are specific customers who are choosing the 20-year phenomenon," says Jim Quinlan, senior vice president at Mortgage Corporation of America in Southfield, Michigan. Quinlan's company plans to originate $500 million in mortgages this year and has seen its 20-year program double in 1993. "It meets their retirement goals. The acceptable age for retirement is around 65, and a 20-year mortgage is within that retirement scope for today's homeowners. It's another financial planning retirement tool for today's mid-40s baby boomers.
"There has been a push for shorter-term loans, like the 15-year and 20-year |loan~, in our refi business. Homeowners want to cut the term of their mortgage. They don't want to go back to the 30-year, especially if they've been in their house awhile. The psychological factor of refinancing is to recognize the years you've been paying off your mortgage, instead of starting all over again at 30 years."
Twenty-year mortgages offer lenders still other advantages. For one, they are a relatively easy product to originate because they are simple, fixed-rate loans. No additional documentation time or extra training is required.
Lenders benefit further by giving the consumer what they want. As Mortgage Corporation of America's Quinlan points out, "The benefit to the lender is that, like many corporations of the 1990s, we're here to satisfy the customer's needs and wants. That's how we'll be successful. The customer wants the price advantage and the better rate that the 20-year often carries. And the customer is number one."
Investors like it
Investors complete the mortgage cycle. And they like these mortgages for many of the same reasons that lenders and borrowers do. Investors favor the reduced interest rate risk of the 20-year product. Generally, the shorter the term, the less likely it is that the mortgage prepays. It's also true that the lower the coupon, the better the security trades. Traders in Freddie Mac's Security Sales and Trading Group have noticed demand for the product is picking up, showing stability in the market in bid-offer spreads.
At least one investor sees the innovation in the marketplace as providing yet another way to participate in mortgage securities. Eric Gutterson, vice president with Back Bay Advisors in Boston, an investment management company with $7 billion in assets, says, "The 20-year has better call protection because of lower initial prepayments and offers attractive incremental yield over the 15-year mortgage security for a minimal extension in average life.
"We can trade in and out of these relatively easily. And the liquidity will improve as the issuance continues, which I expect it will," Gutterson says.
Investors also like the fact that baby boomers are going for these mortgages. Gutterson says, "The 20-year borrower is more likely to stay in the house a long time. They've picked a mortgage that they can substantially pay down before the kids are in college, without the onus of a 15-year mortgage payment."
Fad or fixture?
All in all, the standard loan for homebuyers in the 1960s seems to make sense for many more borrowers today. It's also a lucrative business for lenders and investors. The question remains whether or not the 20-year loan is just a passing fad. Considering that the tail end of the baby boom generation--those born in 1960--are only 33 years old and still approaching prime 20-year borrowing years, suggests otherwise--maybe. The fact is, when lenders promote the mortgage simply by including 20-year rates in advertising, borrowers respond. Perhaps it's a Volkswagen to jump on now, while birkenstocks and beaded belts are still "in."
The 1990s will be an era of debt consolidation, asset accumulation and equity buildup for many American consumers. The 20-year mortgage looks good to these borrowers because the payments are affordable and the product cuts the term of the predominant 30-year loan by one-third.
"It makes a lot of sense," says one borrower, Jim Jackson, of Rancho Cucamonga, California, who recently refinanced from a 30-year to a 20-year mortgage with the North American Mortgage Company, Redding California. "We wanted to pay off our mortgage as quickly as possible. We had about 24 years left to pay, but now we've cut four years off of that and our payments are even lower than they were before," says Jackson.
According to many lenders, the 20-year mortgage makes equal sense from a purchaser's standpoint. On a typical $150,000 loan at rates available in late March, a borrower would save more than $100,000 in interest over the life of the loan by choosing the 20-year mortgage over the 30-year mortgage.
This example shows the comparative monthly payments (without taxes and insurance) and the total interest and principal paid over seven years for a $100,000 mortgage with 30-, 20- and 15-year terms at market rates available in late March. While the monthly payment for the 20-year mortgage is 12 percent more than the 30-year mortgage, the principal reduction over seven years is 160 percent greater. And, compared with the 15-year mortgage, the 20-year monthly mortgage payment is 10 percent lower.
30 years at 20 years at 15 years at 8.25 percent 8.125 percent 7.75 percent Monthly Payment $751 $844 $941 Interest Paid in 7 years $55,890 $52,088 $46,253 Principal Paid in 7 Years $7,216 $18,828 $32,814
FOR THE RECORD
Freddie Mac agrees with the Mortgage Bankers Association of America that the 20-year mortgage should continue to be allowed in both 20-year and 30-year securities. We voiced our opinion in a letter to the Public Securities Association (PSA) in February. PSA is the trade group for broker dealers in government securities, including securities issued by Freddie Mac, GNMA and Fannie Mae. PSA's good delivery guidelines are voluntary rules that govern practices in the trading and settlement of mortgage-backed securities.
In the letter, we stated that lenders should continue to have the flexibility to include mortgages with original terms between 181 and 240 months in 30-year pools. This will be particularly important if the volume of 20-year mortgages diminishes with the fading of the refi market.
In addition, we believe no confusion results from the practice of including 20-year mortgages in 30-year pools. Separate prefixes, which Freddie Mac currently uses, for example, clearly identify 20-year securities.
Specifically, Freddie Mac is concerned with the PSA's position that including a 20-year mortgage in 30-year pools can distort weighted average maturity (WAM) calculations. Freddie Mac leads the agencies in pool disclosure, providing explicit monthly updated data on WAM, weighted average loan age, weighted average original loan term and their respective quartile statistics. As a result, there is no ambiguity as to the term composition of Freddie Mac pools.
Judith Naiman is director-products at Freddie Mac, Washington, D.C.
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|Title Annotation:||includes related articles; 20-year mortgage|
|Article Type:||Cover Story|
|Date:||May 1, 1993|
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