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How Mortgages Work


History of Mortgages

You may think mortgages have been around for hundreds of years -- after all, how could anyone ever afford to pay for a house outright? It was only in the 1930s, however, that mortgages actually got their start. It may surprise you to learn that banks didn't forge ahead with this new idea; insurance companies did. These daring insurance companies did this not in the interest of making money through fees and interest charges, but in the hopes of gaining ownership of properties if borrowers failed to keep up with the payments.

It wasn't until 1934 that modern mortgages came into being. The Federal Housing Administration (FHA) played a critical role. In order to help pull the country out of the Great Depression, the FHA initiated a new type of mortgage aimed at the folks who couldn't get mortgages under the existing programs. At that time, only four in 10 households owned homes. Mortgage loan terms were limited to 50 percent of the property's market value, and the repayment schedule was spread over three to five years and ended with a balloon payment. An 80 percent loan at that time meant your down payment was 80 percent -- not the amount you financed! With loan terms like that, it's no wonder that most Americans were renters.

FHA started a program that lowered the down payment requirements. They set up programs that offered 80 percent loan-to-value (LTV), 90 percent LTV, and higher. This forced commercial banks and lenders to do the same, creating many more opportunities for average Americans to own homes.

The FHA also started the trend of qualifying people for loans based on their actual ability to pay back the loan, rather than the traditional way of simply "knowing someone." The FHA lengthened the loan terms. Rather than the traditional five- to seven-year loans, the FHA offered 15-year loans and eventually stretched that out to the 30-year loans we have today.

Another area that the FHA got involved in was the quality of home construction. Rather than simply financing any home, the FHA set quality standards that homes had to meet in order to qualify for the loan. That was a smart move; they wouldn't want the loan outlasting the building! This started another trend that commercial lenders eventually followed.

Before FHA, traditional mortgages were interest-only payments that ended with a balloon payment that amounted to the entire principal of the loan. That was one reason why foreclosures were so common. FHA established the amortization of loans, which meant that people got to pay an incremental amount of the loan's principal amount with each interest payment, reducing the loan gradually over the loan term until it was completely paid off.

On the next page, we'll break down the components of the modern monthly loan payment and explain the important concept of amortization.