The American housing market is in turmoil, with many homeowners feeling trapped by their low mortgage rates. This lock-in effect has created a significant barrier to mobility, preventing people from selling their homes and moving to new opportunities. However, Denmark's housing finance system offers a promising solution that could transform the way we think about mortgages and homeownership.
In the United States, the typical 30-year fixed-rate mortgage has become both a blessing and a curse. During the pandemic, mortgage rates plummeted to historic lows, with the average rate dropping to about 2.65% in late 2020. While this made homeownership more affordable for many, it also created a situation where homeowners are reluctant to sell their homes as interest rates rise. According to one estimate, the lock-in effect prevented more than 1 million people from selling their homes in just a year and a half.
Denmark, on the other hand, has managed to sidestep this issue through a unique financial innovation known as covered bonds. In Denmark, homeowners can benefit from rising interest rates by purchasing back their mortgages at market value, which is often lower than the original loan amount. This system allows Danish homeowners to sell their homes and move without the financial burden that American homeowners face.
Jesper Berg, the former director of the Danish Financial Supervisory Authority, explains that while the Danish system may seem complex, it is highly efficient. "I simply believe it's a more efficient system that will prevent problems for both individual borrowers who get stuck and for the economy as a whole," Berg noted. The Danish model requires significant changes to be implemented in the U.S., including overhauls of Fannie Mae and Freddie Mac, a massive education campaign for consumers, and possibly even an act of Congress.
One of the key advantages of the Danish system is that it eliminates the lock-in effect. In Denmark, when interest rates rise, the market value of the covered bonds drops, allowing homeowners to pay off their mortgages at a lower cost. For example, if a homeowner has a mortgage with a face value of $500,000 and interest rates rise by 4 percentage points, they could purchase back matching bonds for $400,000. If they sell their home for $700,000, they would pocket $300,000 instead of only $200,000.
This system not only benefits individual homeowners but also helps stabilize the housing market. By making it easier for people to sell their homes, the Danish model increases the pool of available homes, reducing competition and making housing more affordable for first-time and low-income buyers. Additionally, Danish mortgages are assumable, meaning sellers can transfer their loans to qualifying buyers, further enhancing market flexibility.
While the Danish system offers many benefits, it also comes with stricter rules that favor lenders. Borrowers are required to put down 20% of the home's price, and foreclosures are swift thanks to a more creditor-friendly legal system. Despite these challenges, the Danish model provides a compelling blueprint for reforming the American housing market.
Denmark's innovative housing finance system offers a potential solution to America's housing crisis. By adopting similar policies, the U.S. could alleviate the lock-in effect, increase housing affordability, and create a more dynamic and flexible real estate market. As Berg aptly put it, "Although you might not shed tears for homeowners sitting on substantial equity and their attractive mortgage rates, the lock-in effect distorts the entire housing market".
