A mortgage is a loan that makes it possible to buy real estate, whether it's your home or an investment property. The lender provides the money necessary to make the purchase, and the borrower pays that money back—plus interest—in installments, usually over 15 to 30 years. A mortgage also allows the lender to seize your property if you don't make all the payments in a timely way.
History of Mortgages
The Great Depression
Home mortgages were 5- to 10-year loans for only about 50% of the value of the property in the years before the Great Depression. The principal was due as a balloon payment—a large, single, one-time payment at the end of the term. Those loans could be refinanced.
Then housing prices fell by about 25% during the Depression, and homeowners couldn't afford their balloon payments. The banks wouldn't allow refinancing. Approximately 1,000 homes were foreclosed upon every day in 1933.
The New Deal
As part of his larger economic program, President Franklin D. Roosevelt changed five critical housing-related areas as part of the New Deal to respond to the catastrophe:
- The Home Owner’s Loan Corporation bought 1 million defaulted mortgages from banks. It changed them to long-term, fixed-rate mortgages 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.
- The Glass-Steagall Act prohibited banks from investing depositors' funds in risky ventures like the stock market.
These changes weren't designed to be a homeownership policy, but they nonetheless made homeownership more affordable. They extended the term of loans, and this reduced monthly costs and eliminated the need to refinance. Banks funded these mortgages thanks to FDIC-insured bank deposits.
Help Arrives From the VA
The Department of Veterans Affairs mortgage insurance program lowered down payments in 1944. It encouraged returning war veterans to buy the homes that were being built in the suburbs. This spurred economic activity in the home construction industry. Thanks to all the federal programs, homeownership rose from 43.6% in 1940 to 61.9% by 1960.
Savings and Loans' Outsized Impact on Mortgages
As part of its New Deal legislation, the government created a new type of insurance for an old type of bank—the savings and loan—to issue these new, longer mortgages. By 1980 half of all mortgages were originated by S&Ls. To fund those mortgages, these small banks relied on savings account deposits that paid competitive interest rates to account holders. Deposits were backed by the Federal Savings and Loan Insurance Corporation (FSLIC), an FDIC for S&Ls. The S&Ls remained profitable by paying lower interest rates on deposits than they charged on the mortgages.
The 1970s Economy
President Richard Nixon created runaway inflation by severing all ties between the U.S. dollar and the gold standard during the 1970s. Banks lost deposits because they were unable to match the interest paid by other safe investments, such as Treasurys or to investments that were unconstrained by the interest rate caps, like money market mutual funds. This reduced the funding the banks needed to issue mortgages and make money.
Congress passed the Garn-St. Germain Depository Institutions Act to help the banks. It allowed banks to raise interest rates and lower lending standards. It also allowed S&Ls to make commercial and consumer loans. This eventually led to the savings and loan crisis and the failure of many of the nation's S&Ls.
How a Mortgage Works Today
The amount you borrow toward a home purchase is referred to as the principal. The bank will generally lend you up to 90% of the value of the real estate. You must pay the rest through a down payment.
The bank won't lend you the money for free. It will impose interest, depending on the type of mortgage.
Your monthly payment will consist of a combination of principal and interest. You'll pay off the mortgage by making payments against the principal. Every time you make a payment against the principal, the loan amortizes.
Your equity in the property increases as you pay down the mortgage. Your equity can also increase as your home's value rises over time. In fact, your equity can increase dramatically in a hot housing market.
Each type of home loan has its own combination of a down payment, an interest rate, and an amortization schedule. You must be aware of all of them to understand what you're paying each month.
Balance the terms of your mortgage against your situation and needs:
- Take the one with the lowest payment if you don't plan to stay in the house long, and you don't think home prices will rise during that time.
- Get one that allows you to pay as much principal as you can afford if you plan to stay in your home a long time and you think home prices will rise.
Property Taxes and Insurance
Banks might also collect property taxes and insurance premiums and include these in your monthly payment. The bank or loan servicer will hold these in an escrow account for safekeeping and pay the taxes and insurance for you from that account when they come due.
The bank will also charge you for mortgage insurance if your down payment is less than 20% of the home's value. You can stop paying mortgage insurance when you have 20% or more equity in your home.
All mortgages are either fixed-rate or adjustable-rate loans. They're tailored to meet your personal financial needs. The less you pay each month, the longer it will take you to pay it off.
The most popular type of mortgage is the conventional 30-year fixed interest rate loan. It's represented between 70% and 90% of all mortgages since 1999.
The 15-year fixed-rate loan is also widely used. 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.
An FHA loan is guaranteed by the Federal Housing Administration. As a result, banks require as little as 3.5% down payments. You can use gifts from others to make this down payment, but there are some restrictions. There can be no expectation of repayment, and the source of the gift is limited to family members, close friends, and various organizations and government entities.
You must find out from your lender if you qualify for an FHA loan.
Second Mortgages, Home Equity Loans, or Lines of Credit
You can borrow against your equity with a second mortgage. A home equity loan is a one-time loan that you make payments against in addition to your first mortgage.
You can use a home equity line of credit (HELOC) something like a credit card by borrowing what you need when you need it and paying interest on the outstanding amount you've borrowed until you've repaid the principal.
A reverse mortgage also 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 out or die. The loan will be repaid from the proceeds of the sale of the property at that time.
These loans are only available to homeowners age 62 or older.
Exotic and Subprime Loans
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 can be dangerous for first-time borrowers who might not be aware that their payments will rise dramatically after the initial sweetheart phase. Some of the most popular of these loans include:
- Interest-only loans that offer super-low payments that don't reduce the principal for the first few years
- Option ARM loans that allow borrowers to choose how much they pay each month for the first five years
- Negative amortization loans that increase the principal each month while charging interest only
- Ultra-long fixed-rate loans that are 40- to 50-year conventional mortgages
- Balloon loans that must be refinanced or paid off entirely after five to seven years
- No-money-down loans that allow the borrower to take out another loan for the down payment