Another Reason Why Fannie Mae and Freddie Mac Need to Go
The monthly payments a home mortgage has depend on two variables (among others): the initial down payment and interest rates. A larger down payment means a lower mortgage balance; this results in lower monthly payments. Lower interest rates lead to lower monthly payments.
A 2006 study by Fannie and Freddie finds that, by virtue of their existence, homeowners pay 30 basis points (bps) less on interest rates (e.g., a 5 percent interest rate = 500 bps).* The study also highlights how they permit greater homeownership by offering mortgages that require lower down payments. Further, they “estimate the total savings to homeowners from Freddie Mac and Fannie Mae activities reach the $18.8-26.9 billion range.”
That’s an interesting number. But what does this mean for an individual homeowner? I created an amortization table to see:
In World A^, without Fannie and Freddie, a homeowner purchases a $200,000 home with a $40,000 down payment and takes out a $160,000 mortgage with a 5 percent interest rate.
World A monthly payment: $858.91
In World B^, with Fannie and Freddie, a homeowner does the same as in World A, except he or she pays a 4.7 percent interest rate instead (30 bps lower because Fannie of Freddie exist).
World B monthly payment: $829.82
In World C^, with Fannie and Freddie, a homeowner purchases the same home with a lower $20,000 down payment and takes out an $180,000 mortgage at a 4.7 percent interest rate.
World C monthly payment: $933.55
Between World A and World B, which have different interest rates but the same down payment, the homeowner saves $29.09 per month ($349.09 per year). This is ludicrous. At the individual level, one cannot justify saving $29 per month after incurring losses of hundreds of billions of dollars at the expense of all taxpayers.
Between World A and World C, our prospective homeowner is actually worse off because of Fannie Mae and Freddie Mac. Because the down payment is smaller, the mortgage balance is larger thus increasing monthly payments. The homeowner ends up paying an extra $74.64 per month ($895.68 per year) because of Fannie and Freddie. This is super-ludicrous.
Not to be naïve, the homeowner in World C, might not be a homeowner at all, because he or she may not be able to raise $40,000 to buy a home in today’s World A. However this person would be better off renting and saving up for a down payment in the future. In either event, given that the micro-level effect of Fannie Mae and Freddie Mac’s existence is so small or even harmful, they need to go.
*The Federal Reserve estimates (Passmore 2005) that it’s actually only a 7 bps advantage bestowed by Fannie and Freddie. I’m being nice, though, and giving Fannie and Freddie the benefit of the doubt.
^Assumptions: 30-year fixed-rate mortgage. $200,000 is purchase value of home. 5 percent and 4.7 percent are annual interest rates which are then adjusted for 12 monthly periods.