Tuesday, October 29, 2013

5 Ways the Federal Housing Administration changed mortgages forever.


In the dark days of the United States Great Depression, banks had failed, the monetary system all but collapsed, and the real estate marketing was in shambles.  Home ownership was a rarity in those days to being with – by some estimates up to 70% of people rented.  But as people lost their jobs, their incomes, and their trust in the banking system, foreclosures and defaults on mortgages reached epidemic proportions.  So many people walked away from their homes that the banks were forced to “call due” existing notes in an attempt to gobble up whatever cash and assets they could.  But this just quickened the cycle of values plummeting and more people losing their homes.  No banks wanted to lend because of the risk and certainly few people wanted to buy a home under those conditions.  

Something had to be done, so the Federal Government, under President Franklin Delano Roosevelt, initiated the Housing Act of 1934, with the aim to insure loans made by private banks and commercial lending institutions to trigger home buying and home building again.  They knew no amount of monetary policy would be effective if they didn’t build in insurances for banks and consumers – creating confidence in the system, once again.  Part of this Act was the creation of the Federal Housing Administration, the FHA, who’s sole purpose was (and is) to stabilize the mortgage market, regulate rates of interest, and promote home buying.

Here are 5 ways the Federal Housing Administration changed mortgages forever: 

1. Lower down payments.
Prior to the FHA’s new mortgage plan, home buyers traditionally put up to 50% of the home’s value down as a deposit. That means you had to come up with half the value of the property in cash!  But the FHA changed that by lowering down payment requirements, offering mortgages with only 20%, 10%, or even lower deposits.  Thus, 80% and 90% Loan To Value mortgages were born, allowing access for a huge new group of home buyers. 

2. A qualification process.
In the old days, small town banks did business based on a borrower’s reputation in the community.  Basically, they knew the person and the kind of business they did, so they’d vouch for them and approve the loan based on anecdotal information.  The FHA did away with that, instead setting up a structured qualification process based on their ability to repay.  That’s where income qualification ratios and employment verifications factors came in, and later, credit score.

3. Lengthened loan terms.
Up to the time of the Great Depression, mortgage loans were only for 3-5 years, or up to 5-7 for a longer-term loan.  The FHA lengthened the term of the loans to 15 years, and later to 30 years.  Like many of these changes, once the FHA offered these new, improved mortgage provisions, traditional lenders and banks all followed step, to stay competitive.

4. Standards of quality.
In order to bolster confidence and assure the value of a property, the FHA put in play standards of construction.  They mandated a qualified inspection before they allowed a mortgage loan on a home. FHA appraisals factor in 8 criteria, with “Relative Economic Stability," constituting 40% of the appraisal value, and "protection from adverse influences,” another 20%.

5. Amortization.
Traditionally, mortgages only had Interest Only payments, and after the 3-5 year term was up, a big balloon payment for the rest of the balance.  Of course we can see how this led to mass defaults, so the FHA instituted the novel concept of amortization, meaning a set schedule of interest and principal payments every month.  The mortgage started out with heavy interest payments, but as they stayed in the loan and time went down, started paying off their principal more and more.

These measures were wildly successful in turning around the momentum of home ownership in the United States.  In 1935, Colonial Village in Arlington, Virginia was the first large-scale rental housing project built and funded with the Federal Housing Administration’s backing and insurance. From there the economy rebounded and home ownership rates rose to all-time highs a decade later as soldiers came back from World War II and settled back in to their American Dream, with the help of FHA-backed mortgages.  

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