What Is a Mortgage: Types, History, Impact

How Mortgages Affect the U.S. Economy

Most homebuyers need a mortgage.
Mortgage Applications Rise When Consumers Capitalize On Low Interest Rates. By: Joe Raedle/Getty Images

Definition: A mortgage is a long-term loan that is secured by the value of the house. It charges a low interest with a 15 to 30 year term. It is designed to make home ownership more affordable. 

Types

The most popular type of mortgage is the conventional 30-year fixed-interest rate loan. Since 1999, it's represented 70% to 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.

Adjustable-rate mortgages 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. 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 the payment rises dramatically after the initial sweetheart phase. Here are some of the most popular:

History

Before the Great Depression, home mortgages were 5 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 Depression, homeowners couldn't afford the balloon payment. The banks wouldn't allow refinancing. By 1935, 10% of all homes were in foreclosure.

To stop the carnage, the President Roosevelt changed five critical housing-related areas as part of the New Deal:

  1. The Home Owner’s Loan Corporation (HOLC) bought one million defaulted mortgages from banks. It changed them to the long-term, fixed-rate mortgage we know today, and reinstated them. 
  2. The Federal Housing Administration (FHA) provided mortgage insurance.
  3. The Federal National Mortgage Association (FNMA) created a secondary market for mortgages.
  4. The Federal Deposit Insurance Corporation (FDIC) insured bank deposits.
  5. 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 Veterans Administration 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 60s and 70s, almost all mortgages were issued through Savings and Loans (S&Ls). 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 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. This Act  allowed banks to raise interest rates and lower lending standards. It 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. 

Growth of Mortgage Debt
Year    % of Household Income% of Household Assets% of GDP
1949   20   15   15
1979   46   28   30
2001   73   41   50

(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 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, and 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 nearly anyone to become a homeowner. 

As a result, the percentage of mortgage debt compared to Gross Domestic Product (GDP) skyrocketed from 50% in 2000 to nearly 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, AIG, almost went bankrupt. For more, see Understanding the Subprime Mortgage Crisis.