In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi examine how mortgage loan products are structured in other countries and compare them to the prevailing mortgage loan product in the U.S. – the 30-year, fixed-rate mortgage.

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Listen to the REconomy Podcast™ Episode 70:

“One thing is for sure, having long-term, fixed-rate debt in the U.S. protects homeowners from payment shock, acts as an inflation hedge – your primary household expense doesn't change when inflation rises – and is a reason why home prices in the U.S. are downside sticky.”  – Odeta Kushi, deputy chief economist at First American

Transcript:

Odeta Kushi - Hello and welcome to episode 70 of The REconomy Podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey Mark, we are going international for today's episode.

Mark Fleming - Hi Odeta. Looking around, and I'm still in Virginia, though.

Odeta Kushi - And I'm still in D.C. So we're not physically going international, but our topic of discussion will extend beyond the U.S. housing market. In addition to the U.S. housing market, we'll be discussing Australia, New Zealand, Canada and the U.K. housing markets. Specifically, we'll talk about their vulnerability to house price declines through one specific lens -- the structure of mortgage debt in each country,

Mark Fleming - While disappointing that we're not actually recording from any one of those aforementioned countries -- wonderful, all of them -- it's a great and timely topic because all of them have something in common with each other, but that is different from the United States. 

Odeta Kushi - That's right. We are the only country where the dominant mortgage product is a long-term, fixed-rate mortgage, specifically the 30-year fixed rate. And this matters because interest rates have been going up pretty much everywhere as central banks aggressively fight inflation.

Mark Fleming - So let's talk about that 30-year, fixed-rate mortgage. We know that in the U.S. most home buyers generally opt for this mortgage product. According to Freddie Mac, the 30-year, fixed-rate mortgage is the product of choice for nearly 90% of home buyers. We don't like that uncertainty of rate.

Odeta Kushi - That's right. But what led the United States to the 30-year, fixed-rate mortgage? I mean, how did we land on this magical 30 number? Why not 24 or 32?

Mark Fleming - Well, I guess it's history lesson time. And on this podcast, of course, we love our history lessons. As we've talked about before, a typical mortgage in the early 1900s might have a term of five years and require a 50% down payment. Plus, they were usually structured interest-only monthly payments, and the balloon payment for the entire principal at the end of that very short five-year term. This was okay until the Great Depression hit, then banks stopped lending and borrowers were left without any cash.

Odeta Kushi - Enter President Franklin Delano Roosevelt who launched the New Deal in 1933 to stabilize the housing market and to buy failing mortgages and switch them into longer term loans with payments that included interest and principal, the U.S. government created the Home Owners Loan Corporation in 1933. Then came the Federal Housing Administration in 1934, which created the 15-year mortgage and then pushed it to 20 years and 30 years. So I guess there's no reason it was 30, except maybe it was a nice round number.

Mark Fleming - That's probably true. And I recall, in more recent decades, conversations about a 40-year mortgage, right. And because of this, from the perspective of a borrower, a 30-year, fixed-rate mortgage is pretty great news. More predictable payments for 30 years, the rate is fixed, over a longer period of time. And you can buy more with less per month, given that longer time period to pay it all back. That is a big boost to affordability.

Odeta Kushi - Right? I mean, so a borrower likes it. But why would a lender ever agree to it, we know that banks borrow money and pay interest to depositors and that interest isn't fixed.

Mark Fleming - And we really know how good everyone is at forecasting interest rates, let alone five years, let alone 30 years into the future.

Odeta Kushi - It's a humbling experience, especially these days.

Mark Fleming - That's where Fannie Mae and Freddie Mac come in. In the 1970s, Congress authorized them to buy mortgages from lenders, which as we've discussed in a previous episode, removes that risk from the lender. And the GSEs instead assume the associated credit risk and liquidity risk. Got to mention it creates a source of new capital for the lenders, lenders receive a lump sum of money when they sell that mortgage to the GSE, which allows them to turn around and lend more again.

Odeta Kushi - And, of course, the amortization schedule of a 30-year, fixed-rate mortgage is pretty interest-rate heavy at the beginning. If you've ever looked at your amortization schedule, you're know you're paying a lot of interest upfront, right? So we know that the 30-year fixed rate mortgage is fixed, but the composition of that payment will change monthly until the loan term ends. As I just mentioned, you're paying mostly interest at the beginning, but mostly principal towards the end of the loan term. But the fact that you're paying mostly interest in the beginning means that lender is getting paid up front.

Mark Fleming - That's right. 

Odeta Kushi - All right. So moving right along. Most Americans take out a 30-year, fixed-rate mortgage. This is not the case in other countries. How does it work in let's say the U.K.? I don't know if our listeners know this, but Mark is from the U.K. So it's a only appropriate that you explain how mortgages work.

Mark Fleming - So true. Little known fact about me, I moved here from the U.K. when I was seven years old. Many people in Britain have mortgages with a rate that is fixed for only a short period, commonly two or five years. Unlike U.S. mortgage rates, which as we've mentioned, are often fixed for 30. At the end of the much shorter fixed period, mortgage holders can shop around for different offers. Usually choosing between a variable-rate mortgage, which can move up and down whenever the lender decides or with interest rates, or another fixed-rate loan. 

Odeta Kushi - I actually read a New York Times analysis which stated that in Britain, over a third of households own their homes free and clear, about the same percent rent their homes, and the remaining 28% of households have a mortgage. But the good news is that due to the prevalence of fixed-rate mortgages, not everyone will feel the impact of today's higher rates right away, right?

Mark Fleming - True, not right away. But remember, these are shorter term fixed-rate mortgages. And, according to the Bank of England, by the end of this year, about 3 million mortgage holders will experience an increase of up to $650 a month on their payments, and about 4.5 million households have already seen an increase in payments since the Bank of England started raising interest rates in December of 2021. So millions of U.K. residents are being forced to rearrange their household budgets because their rates essentially aren't fixed.

Odeta Kushi - That's tough. That's a tough increase. And just to be clear, longer term, fixed rates over five years are available in the U.K., but they tend to be more expensive or have more burdensome early repayment charges. And so they're less popular than shorter term fixed rates. But what about our northern neighbors?

Mark Fleming - Well, it's actually similar in Canada, the standard mortgage in Canada isn't the 30-year, fixed-rate mortgage as in the U.S., but a five-year mortgage that amortizes over 25 years. That means the loan balance has to be refinanced at the end of the five-year period, exposing the borrower to any increase in rates that has occurred. Prepayment penalties for borrowers hoping to take advantage of any decline in interest rates, however, can be quite high. So they're really trying to lock you in to five-year chunks and force you to play in the market at the end of that five-year period.

Odeta Kushi - It's important to note that Canadian mortgages are portable. So if you move before the five-year term, you can apply your old mortgage to your new home. So we know that interest rates have increased a lot. So the option for someone who can no longer afford their mortgage is either to sell perhaps at a discount and a higher rate environment, or default.

Mark Fleming - Yes, but there is one other option, it's called negative amortization.

Odeta Kushi - Ah yes, dun, dun, dun. It's not that that bad. Negative amortization, simply put, is when borrowers are adding to their principal. It happens when a borrower's monthly repayments are not enough to cover the interest component of the loan. That excess amount gets added to the outstanding loan and lengthens the repayment period.

Mark Fleming - But I assume not all banks necessarily offer negative amortization on those loans.

Odeta Kushi - That's correct. So, of course, there is some concern. In Canada the cost of a floating-rate mortgage has now increased by about 70% since October 2021, when interest rates hit a record low when more than half of home buyers took out floating-rate loans. Analysts estimate some $251 billion in mortgages are coming up for renewal in 2024 and $265 billion the following year. So there's a major refinancing challenge if rates stay high or go higher. Alright, so what about Australia and New Zealand?

Mark Fleming - Well, according to an analysis from the Parliament of Australia, only a minority of Australian borrowers take out fixed-rate mortgages, and almost all fixed-rate mortgages in Australia are short- to medium-term, with fixed-rate periods, typically lasting from one to five years. So there's hardly any long-term, fixed scenarios there.

Odeta Kushi - And, according to reporting from The Economist, in New Zealand, fixed-rate mortgages make up the bulk of existing loans, but nearly three-fifths are fixed for less than a year.

Mark Fleming - That's hardly fixed at all, if it's only one. The basic point here is that in the U.S., where most homeowners have 30-year, fixed-rate mortgages, when rates rise, one very important option for the homeowner is to simply do nothing. Keep paying the mortgage at the low fixed rate and wait out those higher interest rates. Not so in all of these other countries. Borrowers are forced back into the mortgage market by the structures of the loans themselves. So how are house prices faring in all of these markets with these different structures?

Odeta Kushi - Well, what's interesting is that many of these countries experienced some of the highest price increases over the pandemic, so we can use the Federal Reserve Bank of Dallas's International House Price database to analyze yearly price growth in 25 different countries. And when we do that, we find that of those 25 have countries, Canada and New Zealand experienced the strongest year-over-year price growth. Canada peaked at 31.3%. And Mark, before you say anything, decimal detail is necessary here, because New Zealand followed closely at 30.5%. Australia was fourth at 24%.

Mark Fleming - Are you sure, you haven't rounded the 24 from something?

Odeta Kushi - I actually have, I can double-check right now, if you're willing to wait. The U.S. was fifth at 21% and the U.K. was 16 at 12%. But in the latest Q1 2023 data, it seems three out of five have experienced yearly price declines. So Canada's house prices are down nearly 16% year over year, New Zealand is down 7%, Australia down nearly 4%. The U.S. and U.K. are actually still up on a yearly basis. Although we know from monthly U.S. house price data that house prices in the U.S. are technically modestly down on a yearly basis because the comparison point is last year's peak, but house prices in the U.S. have actually re-accelerated on a monthly basis.

Mark Fleming - So to bring it all back to the topic of mortgage debt, house price declines in these countries may in part be due to the fact that homeowners suddenly face higher monthly mortgage payments and are forced to sell their houses. We know in the U.S. that there is a severe supply shortage driven in part by the fact that homeowners are exercising that option to do nothing that the 30-year, fixed-rate mortgage affords them. And that, relative to demand, is keeping the floor on house price declines.

Odeta Kushi - Yes, that rate lock-in effect that we're always talking about. So the predominance of the 30-year, fixed-rate mortgage is a reason house prices have accelerated in the U.S. and it's likely the cause of still positive house prices in the U.K. I should also note that a strong labor market can help prevent housing distress from turning into housing foreclosure. And we know that Canada's job market has remained strong. But going back to our main point, one thing is for sure, having long-term, fixed-rate debt in the U.S. protects homeowners from payment shock, acts as an inflation hedge -- your primary household expense doesn't change when inflation rises -- and a reason why home prices in the U.S. are downside sticky.

Mark Fleming - Those are great points. The U.S. homeownership rate is 66%. Which means, while the cost of food, goods and services has increased with inflation recently, shelter costs for roughly two-thirds of all American households have not for all of those homeowners. That's true.

Odeta Kushi - The fact that there's the option to wait and stay put also weakens the Fed's transmission mechanism.

Mark Fleming - I thought we could get through an episode without discussing the Fed.

Odeta Kushi - We almost did it. But I think this is an important point, given today's discussion. The transmission effect of monetary policy through housing may be faster in other countries, because in the U.S. consumers may not pull back on their spending because of an expectation of higher housing costs, because homeowners can just wait it out for 30 years. All right. I think we covered quite a bit in this episode. We hope you enjoyed this episode of the REconomy International Edition. I petition that for the next international edition, we film abroad. I don't know my vote would be for like a Portugal.

Mark Fleming - Oh, if only.

Odeta Kushi - You can't say I didn't try. All right. Thank you for joining us on this episode of The REconomy Podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at economics@firstam.com. We love to hear from our listeners. And, as always, if you can't wait for the next episode, you can follow us on X. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.

Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2023 by First American Financial Corporation. All rights reserved.

This transcript has been edited for clarity.