In most of the world, homeownership isn’t seen as a natural step in the progress toward responsible adulthood. Outside the U.S., mortgages are for small amounts, for shorter times, and have adjustable interest rates. The popular U.S. 30-year mortgage with a fixed rate, which makes possible low monthly payments and a more certain future, is an oddity.
How did Americans develop such a peculiar financial practice? The New Deal.
In many ways, the mortgages of the 1920s resembled the more exotic ones of today. Balloon loans with terms of just three to five years were common. Homeowners, like those of the 2000s, simply expected to be able to refinance. The money for these mortgages, in an eerie echo of today, came from debt that banks sold to investors, and the bond-repayment periods were equally short.
As investors became skittish after the stock-market crash of 1929, investors stopped buying mortgage bonds. Banks no longer had the capital to refinance homeowners, and no one could refinance their mortgages. The only thing that prevented the collapse of the housing market was the Home Owners’ Loan Corporation, a government-sponsored enterprise, which started swapping bonds of its own for bank mortgages, injecting liquidity into the system.
Understandably, when policy makers started to think about how to reform the system, they tried to find ways to make mortgage borrowing and lending have longer terms, so that a crisis wouldn’t be self-perpetuating. In 1934, the Federal Housing Administration introduced an audacious plan to remake the way Americans borrowed.
In 1933, much as today, private capital was piling up in banks that were too afraid to lend. President Franklin D. Roosevelt tapped James Moffett, a vice-president of Standard Oil Co., to oversee the new agency. Both agreed that capital needed to flow nationally for the economy to reignite. Roosevelt thought that a national mortgage market would be more stable and just. Writing to Moffett, he reaffirmed “that the refunding of existing mortgages in long term, amortized mortgages” would “result in a safer mortgage structure for the country.”
But FDR wasn’t just concerned with market stability; he shared the American “conviction that every practical attempt at lowering the cost of homes to the great mass of our people is worthy of our best efforts.”
The most imaginative part of the FHA plan was that the government wouldn’t pay for any of it. Lenders would contribute to an insurance pool organized by, but not funded by, the federal government. If there was a default on a mortgage, the lender would be paid out of the pool. Paid in low-yielding bonds, the lender wouldn’t lose the principal of the mortgage, but neither would the lender have an incentive to lend to the unworthy. With such a long repayment period, the monthly installments could incorporate both interest and principal.
Mortgage amortization, as such a plan was called, eradicated the need for refinancing, which made the balloon mortgages so precarious. A long period made the mortgages independent of short-term fluctuations in the economy. Borrowers wouldn’t have to weather both unemployment and refinancing at the same time.
The FHA preserved private choice while accomplishing a public good. No lenders had to comply with the FHA, but if they did, their business would be much easier to conduct. Risk-free loans with guaranteed buyers provided an incredible -― and noncoercive -― incentive to lend private capital.
The FHA’s plan was a revolution in finance. No longer would homeowners borrow on balloon notes for a few years. Instead they could borrow for 15 or 20 years (a length of time that bankers had previously thought was immorally long). The loans could only be used for good housing that would last for decades, and the FHA would inspect all the houses to make sure they met standards. The new thinking was that it was more immoral to create a situation where homeowners would be foreclosed on.
As Time magazine described it, the new system was a departure from the “old-fashioned mortgage that was renewed in good times and foreclosed in bad.” The FHA insured the loans so that private capital sources, such as banks and insurance companies, would invest in them. Moffett authorized pamphlets explaining how the building and banking industries could both profit from the FHA. Animosity toward government spending remained, but support for the FHA increased.
With guaranteed mortgages, the risk fell to nothing, allowing Roosevelt to mandate that the FHA mortgages paid a low fixed rate of 5 percent (compared with the market rate of 12 percent) nationwide. Moral or not, long-term mortgages stabilized the housing market and increased the quality of U.S. housing stock, bringing a new expectation of long-term mortgages to the American borrower.