What Are Mortgages? Their Types, History, and Impact on the Economy
How Mortgages Affect the U.S. Economy
A mortgage is a real estate loan that allows the bank to take your property if you don't make all the payments. Mortgages charge a low interest rate over 15 to 30 years. They are designed to make homeownership more affordable.
How a Mortgage Works
The amount you borrow is the principal. The bank lends you up to 90% of the value of the real estate. You must pay the rest with a down payment.
The bank won't lend you the money for free. It needs a return for tying up its money. That's the interest. It's typically 3% to 4% of the principal.
Your monthly payment consists of some combination of principal and interest. You pay off the loan by making payments against the principal. Every time you make a payment against the principal, it amortizes it.
As you amortize the loan, you increase your equity in it. Your equity also increases as your home's value rises over time. In a hot housing market, your equity can increase dramatically.
Each loan has its own combination of down payment, interest rate, and amortization schedule. You must be aware of all of them to understand what you are paying each month.
On top of that, the bank may also collect property taxes. It will hold these in an escrow account for safekeeping. It will pay the taxes for you from that account. The bank may also collect and pay for homeowners' insurance.
If your down payment is less than 20% of the home's value, the bank will also charge you for mortgage insurance.
All mortgages are based on either fixed-rate or adjustable-rate loans. They are tailored to meet your personal financial needs. The most important thing to remember is that the less you pay each month, the longer it will take you to pay off your loan. That also means you'll have less equity.
If you don't plan to stay in the house long, and you don't think home prices will rise, then take the loan with the lowest payment.
If you plan to stay in your home a long time, and you think home prices will rise, then get a loan that allows you to pay as much principal as you can afford.
If you think housing prices will fall, then rent until you believe prices have hit bottom.
The most popular type of mortgage is the conventional 30-year fixed-interest rate loan. Since 1999, it's represented between 70% and 90% of all mortgages. The 15-year fixed rate loan is also widely-used, as it allows people to pay down their debt in half the time.
These loans offer lower interest rates and monthly payments than fixed-rate loans. They will become more expensive when interest rates rise from today's 200-year lows.
Subprime lenders created a host of exotic loans based on adjustable rate mortgages. They attracted customers by offering low "teaser" rates for the first couple of years. These are dangerous for new borrowers. They might not be aware that the payment rises dramatically after the initial sweetheart phase. If you run into any of these, beware. Here are some of the most popular:
- Interest-only loans: Super-low payments that didn't reduce the principal for the first few years.
- Option ARM loans: Borrowers choose how much to pay each month for the first five years.
- Negative amortization loans: Interest-only loans that increase the principal each month, as the payment was less than even the interest.
- Ultra-long fixed rate loans: These are 40-50-year conventional mortgages.
- Balloon loans: They must be refinanced or paid off after 5-7 years.
- No-money-down loans: These allowed the borrower to take out a loan for the down payment.
An FHA loan is guaranteed by the Federal Housing Administration. As a result, banks only require a 3.5% down payment. You can use gifts from others to make this down payment. There are some pitfalls. You must find out from your lender if you qualify for a FHA loan.
Second Mortgage, Home Equity Loan, or Line of Credit:
You use a home equity line of credit, or HELOC, like a credit card. You can borrow what you need when you need it. You pay interest on the outstanding amount you've borrowed until you repay the principal.
A reverse mortgage allows you to borrow against the equity in your home. The difference is that the bank pays you each month. It doesn't expect repayment until you move or die. At that time, the loan will be repaid from the proceeds of the sale.
To get the best rate, make sure your credit score is 720 or better. Otherwise you're operating at a disadvantage.
Longer-term loans with a higher down payment will have lower rates than short-term loans. Depending on your situation, the lowest rate may not meet your personal financial goals.
It pays to shop around. But make sure you do so within a 45-day window. Otherwise, it could affect your credit score.
With all this complexity, it may pay to use a mortgage broker. They do charge a fee that equals between 1% and 2% of the loan amount. But it could be worth it if they find a better rate than you could on your own.
A broker is especially helpful for borrowers who are self-employed or have bad credit. If you don't have the time to shop or know you're not good with numbers, you might also find a broker is right for you.
Refinancing Pros and Cons
Before the Great Depression, home mortgages were 5-year to 10-year loans for only 50% of the value of the home. The principal was due as a balloon payment at the end of the term. Banks had little risk.
When housing prices fell 25% during the Great Depression, homeowners couldn't afford the balloon payment. The banks wouldn't allow refinancing. By 1935, 10% of all homes were in foreclosure.
- The Home Owner’s Loan Corporation bought 1 million defaulted mortgages from banks. It changed them to the long-term, fixed-rate mortgage we know today, and reinstated them.
- The Federal Housing Administration provided mortgage insurance.
- The Federal National Mortgage Association created a secondary market for mortgages.
- The Federal Deposit Insurance Corporation insured bank deposits.
- Glass-Steagall prohibited banks from investing depositors' funds in risky ventures like the stock market.
These changes responded to an economic catastrophe. They were not designed to be a homeownership policy. Even so, they did make homeownership more affordable. They extended the term of the loan. That reduced monthly costs and eliminated the need to refinance. Banks funded the loans thanks to FDIC-insured bank deposits.
In 1944, the Department of Veterans Affairs mortgage insurance program lowered down payments. It encouraged returning war veterans to buy homes being built in the suburbs. That spurred economic activity in the home construction industry. Thanks to all the federal programs, homeownership rose from 43.6% in 1940 to 64% by 1980.
The government created special legislation to create savings and loans banks to issue these mortgages. Throughout the 1960s and 1970s, almost all mortgages were issued through savings and loans. These banks were successful because people deposited funds in savings accounts. The government insured the deposits, so people used the accounts, even though the interest earned wasn't much. This was also regulated by the government. The S&Ls could stay remain profitable by paying lower interest rates on deposits than they charged on the mortgages.
In the 1970s, President Richard Nixon created runaway inflation by severing all ties between the U.S. dollar and the gold standard. Banks lost deposits since they were unable to match the interest paid by money market accounts. This reduced the funding they needed to issue mortgages.
To help the banks, Congress passed the Garn-St. Germain Depository Institutions Act. It allowed banks to raise interest rates and lower lending standards. It also allowed S&Ls to make commercial and consumer loans. This led to the savings and loan crisis and the failure of half the nation's banks.
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(Source: Richard K. Green and Susan M. Wachter, "The American Mortgage in Historical and International Context," University of Pennsylvania, September 21, 2005)
How Mortgages Affect the Economy
During President Bill Clinton's administration, banks complained they couldn't compete in the international financial markets. Congress deregulated the industry and repealed the Glass-Steagall Act. This allowed banks to use depositors' guaranteed funds to invest in risky derivatives. The most popular of these was the mortgage-backed security.
Banks would bundle together similar mortgages. They would then sell them to Fannie Mae, Freddie Mac, or other investors. They were insured against default by credit default swaps. The demand for these securities was so high that banks began lowering standards on the underlying loans. Soon, these subprime mortgages allowed almost anyone to become a homeowner.
As a result, the percentage of mortgage debt compared to gross domestic product skyrocketed from 50% in 2000 to almost 70% by 2004. All went well until housing prices started to drop in 2006. Unable to refinance or sell their houses, homeowners began defaulting. So many investors cashed in their credit default swaps that the principal insurer, American International Group, almost went bankrupt. That's how the subprime mortgage crisis created the 2008 financial crisis.