Financial History Issue 113 (Spring 2015) | Page 12

EDUCATORS’ PERSPECTIVE Financing the American Dream: A History of the Fully-Amortized 30-Year Mortgage A “dead pledge” sounds more like a contract that Captain Jack Sparrow might enter into than the typical American family. Yet for many who aspire to the American Dream of homeownership, that’s exactly what they’re agreeing to when they finance their homes with a mortgage. The literal meaning of the term “mortgage,” according to the Oxford English Dictionary, is “dead (from the Old French term ‘mort’) pledge (from the Old Germanic term ‘gage’).” Today the American Dream home is likely to be financed with a fullyamortized fixed-rate 30-year mortgage. The astute reader will notice that the term “mort” is also a component of the word “amortize,” which literally means “to death.” Is the American Dream of homeownership a dream financed under a double death threat? Fortunately, it’s not as morbid as it seems. According to The Word Detective, “The logic of ‘mortgage’ is that of a ‘dead pledge,’ meaning that if the borrower repays the loan as agreed, the property becomes ‘dead’ to the lender, who has no further rights to it. And if the borrower fails to pay, all of his or her rights to the property cease.”1 To “amortize” a loan means to slowly kill off the principal or amount borrowed. With an amortized loan, part of each fixed payment goes toward paying off the interest owed for the period of time since the last loan payment. The remainder of the payment goes towards paying off the principal. With a fully-amortized mortgage, the entire principal is fully paid off when the last payment is made and the borrower owes nothing more on the loan. The fully-amortized mortgage is an innovative financial instrument that came into common use during the Great Depression. Real estate economists Richard K. Green and Susan M. Wachter remind us that “The US mortgage before the 1930s would be nearly unrecognizable today.” In spite of the increase in homeownerships during the 1920s, most families did not own their own homes. Loan-to-value ratios were typically 50% or less, meaning that a down payment of at least 50% was required to qualify for a mortgage.2 Many homeowners were unable to save up for the hefty down payment and financed it by taking out a second mortgage from a non-traditional lender, such as the previous homeowner or a homebuilder, at a higher rate of interest than Collection of the Museum of American Finance By Dan Cooper and Brian Grinder Specimen financial statement from the Minnesota Building and Loan Association. the first mortgage. Most mortgages were of the interest-only variety,3 were financed for short-term periods from five to 10 years and required a balloon payment of the remaining principal at the end of the loan’s life. As a result, borrowers were constantly refinancing or renegotiating the terms of 10    FINANCIAL HISTORY  |  Spring 2015  | their loans, some on a yearly basis. These types of loans worked well as long as house prices remained stable or increased, but in a market downturn, they spelled trouble. “B&Ls [Building and Loan Associations],” writes economic historian Kenneth A. Snowden, “were the only lenders to write amortized, long-term mortgages in the late 19th century.” A B&L, according to Snowden, “was a small, local and undiversified mutual fund into which members contributed weekly or monthly dues; the pooled dues were then lent to members who chose to purchase…homes. The interest payments and fees on these loans, net of expenses and loan losses, were returned to members as dividends.” B&Ls were an important source of mortgage loans in the 1920s.4 They used what was known as the “Philadelphia Plan” or share accumulation loan plan to simulate an amortized mortgage. Under this plan, the borrower obtained an interest-only loan, often from a bank, for less than 60% of the home’s value. The B&L then required the borrower to make monthly payments that were used to purchase shares of the B&L. When the value of the accumulating shares and the dividends earned on those shares equaled the loan’s principal, the mortgage was paid off, and the homeowner was given full title to the property. A potential problem occurred if the value of the shares fell because it forced the borrower to make additional payments in order to pay off the principal. B&L share prices dropped dramatically during the Great Depression as house prices also dropped. Many homeowners, who were either unable to make their interest payments or, worse yet, unable or unwilling to refinance their loans, exacerbated the situation. Although financial institutions displayed a great deal of forbearance,