What Are Mortgages? Their Types, History, and Impact on the Economy
How Mortgages Affect the U.S. Economy
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.
The most popular type of mortgage is the conventional 30-year fixed-interest rate loan. Since 1999, it's represented 70 percent to 90 percent 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 that the payment rises dramatically after the initial sweetheart phase. 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.
Before the Great Depression, home mortgages were 5 to 10-year loans for only 50 percent 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 percent during the Great Depression, homeowners couldn't afford the balloon payment.
The banks wouldn't allow refinancing. By 1935, 10 percent of all homes were in foreclosure.
- The Home Owner’s Loan Corporation bought one 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 percent in 1940 to 64 percent 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 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 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 almost anyone to become a homeowner.
As a result, the percentage of mortgage debt compared to gross domestic product skyrocketed from 50 percent in 2000 to almost 70 percent 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.