Down payment is an ever-present issue in any home buying scenario. And a working paper in August by members of the Board of Governors of the Federal Reserve System proposes to improve the 30-year fixed-rate mortgage and take note, with no down payment.

Sure, there are no down payment mortgages available in the market such as VA and USDA loans. But what makes the Fed’s idea tick, inciting various reactions from the mortgage industry, is that the newly improved 30-year mortgage is a product deemed safe for both consumers and banks.

So, how does this no-down mortgage work or rework the 30-year mortgage so more consumers, especially renters, gain access to homeownership?

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Large Down Payments, Prepayment Costs Dominate Today’s 30-Year FRM

In their working paper, Wayne Passmore and Alexander H. von Hafften of the Division of Research and Statistics at the Fed’s Board of Governors acknowledged that the 30-year fixed-rate mortgage was a substantial innovation made during the Great Depression.

But it has three major flaws that, according to the researchers, “impede homeowner equity accumulation and access to homeownership …” These are:

1. Large down payments. “The first flaw is that many lenders require large down payments to offset default risk because homeowner equity accumulates very slowly during the first decade of traditional fixed-rate mortgages. Because early payments of traditional fixed-rate mortgages are almost entirely interest, homeowners are essentially renting their homes from lenders,” Messrs. Passmore and von Hafften wrote.
2. Prepayment risks. “Second, homeowners substantially compensate capital markets for the option to prepay their mortgage. Prepayment risks associated with fixed-rate mortgages are notoriously difficult to hedge. Some homeowners may be better off directing this money to other purposes,” according to the researchers.
3. Refinance costs. “Third, refinancing traditional fixed-rate mortgages is often very costly. Typical refinancing costs are several percent of the mortgage principal. In addition, because many households miss optimal refinancing opportunities, not all households benefit when rates fall,” they said.

Against this backdrop, the researchers propose a new mortgage that resolves those three major flaws of the 30-year FRM while preserving its fixed payments scheme.

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The Fixed-COFI Mortgage

The researchers called their new mortgage design as Fixed-Payment-COFI mortgage, or Fixed-COFI mortgage. This mortgage has three main features.

1. No down payment. Fixed-COFI mortgages can be offered with negligible down payments, thus encouraging rapid equity accumulation, according to the researchers.
2. Redirecting prepayment risk. The compensation to capital investors from prepayment will be directed toward home equity accumulation instead.
3. No refinance costs. The Fixed-COFI mortgage will avoid the costs associated with refinancing as homeowners can always reap the benefits of falling interest rates.

At the core of the Fixed-COFI mortgage is an adjustable-rate mortgage. “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,” the researchers explained.

They wrote that households can’t freely spend savings from refinancing on non-housing items. “When mortgage rates fall, homeowners with Fixed-COFI mortgages automatically pay less interest and pay down the mortgage principal more.”

“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,” they added.

The researchers also believe that Fixed-COFI mortgages might help renters achieve homeownership as they might be paying rents comparable to mortgage payments but have no down payments to buy a home.

In a broader context, the researchers believe that Fixed-COFI mortgages could lessen government involvement in the mortgage market. As these mortgages rapidly accumulate equity, there’s less risk for the government to absorb in the long run.

Fixed-COFI mortgages are also expected to increase financial stability as it does away with refinancing, which contributes to interest rate spikes.

Mortgage Stakeholders React

With no down payments, fixed payments and lower rates, what could go wrong?

There’s the restriction to refinance that won’t allow homeowners to reduce their monthly payments. Mortgage Bankers Association Chief Economist Mike Fratantoni said in an interview with Bankrate that this is not how mortgage markets work and could make the proposed mortgages difficult to sell.

American National Bank of Texas CFO Robert Messer also noted in the same article that the idea could work in a falling-rates environment but when rates go up, equity accounts could go negative. Karen Shaw Petrou, co-founder and managing partner at Federal Financial Analytics, added in the article, “Anything that has nontraditional risks, which this mortgage product does, raises significant issues.”

If anything, the proposal is not final but is meant to stimulate discussion as all other working papers submitted to the Fed.

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