WASHINGTON — Economists at the Federal Reserve are suggesting an intriguing new alternative to the traditional 30-year fixed mortgage that could be better for consumers, more profitable for banks, and safer for both.
In a paper last month, they proposed a new mortgage product that would allow home buyers to build equity faster than the standard 30-year fixed-rate mortgage with little or no down payment. This mortgage is built around a cost of funds index, or COFI, which the researchers calculated by dividing the total interest expenses of domestic commercial banks by their total interest-bearing liabilities.
"The fixed-COFI mortgage exploits the often-present prepayment-risk wedge between the fixed-rate mortgage rate and the estimated cost of funds index mortgage rate," according to a paper written by Federal Reserve Board senior adviser Wayne Passmore and Alexander von Hafften, a senior research assistant at the Fed.
"In addition, banks can hold a fixed-COFI mortgage profitably, and their credit risk concerns are often mitigated soon after origination because of rapid equity accumulation."
In a falling interest rate environment, the COFI mortgage automatically adjusts so the borrower pays less interest and pays down the mortgage principal more quickly. Under the product, equity accumulates faster than traditional fixed-rate mortgages and there is less incentive to refinance. However, borrowers still retain the option to refinance.
"We believe that many households may prefer fixed-COFI mortgages to traditional fixed-rate mortgages," according to the Fed paper, particularly in cases where the "spread between the fixed rate mortgage rate and the one-year Treasury yield is relatively high."
They also expect the fixed-COFI mortgage will be a "highly profitable asset for many mortgage lenders." And this mortgage product might also open the door for more renters to become homeowners.
"We believe that many renting households without savings for a down payment may prefer fixed-COFI mortgages to renting," the paper said.
Industry observers said the idea has merit.
"Reminiscent of other mortgage products that prioritize equity-building, the researchers believe and we agree that their new product advances housing equality because of its easier entry point (no down payment) and more certain path to equity retention," said a Sept. 7 paper by Federal Financial Analytics.
"By choosing the fixed-COFI mortgage, the paper says that borrowers will lose the ability to spend refinancing gains on non-housing items. Instead, when mortgage rates fall, they effectively automatically refinance and pay less interest and more mortgage principal."
Edward Pinto, a resident fellow at the American Enterprise Institute and co-director of the institute's International Center on Housing Risk, said it "is an innovative and well-thought-out idea."
Historically, there has always been a difference between the COFI rate and the 30-year fixed mortgage rate, except in a few instances.
"The big plus is the potential for wealth building," Pinto said, since the authors found the average maturity of fixed-COFI mortgages to be 23 years, so long as the borrower did not refinance or extract equity.
But some suggested it might be too different from current products to catch on.
"The fixed-payment COFI mortgage is an intriguing but quite complicated product," said Glenn Corso, executive director of the Community Mortgage Lenders of America and a former private mortgage insurance executive.
"I think it would take a tremendous amount of borrower education to get consumers comfortable with the product," he said. And it will take a "great deal of bank and/or investor education to get lenders comfortable with the product."
Under the plan, a financial institution essentially guarantees the loan will be paid off in 30 years and the borrower will never pay more than the initial interest rate, which is based on the 30-year fixed mortgage rate.
If the difference, or "wedge," between the 30-year rate and COFI rate is 1%, that difference is used to pay down the mortgage faster. However, in a rising interest rate environment, the lender would have to hedge to preserve the borrower's equity.
The Passmore-von Hafften paper lays out how institutions should hedge against that risk.
However, it's a complex product, Pinto noted, and there's a question of whether many financial institutions will be interested in offering the fixed-COFI mortgage. There is also a potential hurdle in the difficulty of explaining it to consumers so they can understand it.
Not everyone in the industry, moreover, is enamored of the idea.
Michael Fratantoni, chief economist of the Mortgage Bankers Association, said the group is very wary of the fixed-COFI mortgage product due to restrictions on prepayments.
In one version of the fixed-COFI mortgage, there is no prepayment allowed during the life of the 30-year mortgage. In another version, refinances are allowed only if rates drop by 2% or more, according to the MBA.
"In the current regulatory environment, prepayment penalties are severely restricted," Fratantoni said. "I don't think either U.S borrowers or the U.S. regulatory system would permit these products to be widely available. And I don't think you would see a lot of demand or take-up in the market."
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Corrected September 14, 2017 at 2:26PM: A previous version of this story misstated the index used to price the proposed mortgage product. It is a cost of funds index that the researchers derived from bank financial reports, not the Federal Home Loan Bank of San Francisco's COFI.