Written by Michael J. Highfield, Professor of Finance and Warren Chair of Real Estate Finance, Mississippi State University
The average interest rate for a new U.S. 30-year fixed-rate mortgage topped 7% in late October 2022 for the first time in more than two decades. It’s a sharp increase from one year earlier, when lenders were charging homebuyers only 3.09% for the same kind of loan.
Several factors, including inflation rates and the general economic outlook, influence mortgage rates. A primary driver of the ongoing upward spiral is the Federal Reserve’s series of interest rate hikes intended to tame inflation. Its decision to increase the benchmark rate by 0.75 percentage points on Nov. 2, 2022, to as much as 4% will propel the cost of mortgage borrowing even higher.
Even if you have had mortgage debt for years, you might be unfamiliar with the history of these loans – a subject I cover in my mortgage financing course for undergraduate business students at Mississippi State University.
The term dates back to medieval England. But the roots of these legal contracts, in which land is pledged for a debt and will become the property of the lender if the loan is not repaid, go back thousands of years.
Historians trace the origins of mortgage contracts to the reign of King Artaxerxes of Persia, who ruled modern-day Iran in the fifth century B.C. The Roman Empire formalized and documented the legal process of pledging collateral for a loan.
Often using the forum and temples as their base of operations, mensarii, which is derived from the word mensa or “bank” in Latin, would set up loans and charge borrowers interest. These government-appointed public bankers required the borrower to put up collateral, whether real estate or personal property, and their agreement regarding the use of the collateral would be handled in one of three ways.
First, the Fiducia, Latin for “trust” or “confidence,” required the transfer of both ownership and possession to lenders until the debt was repaid in full. Ironically, this arrangement involved no trust at all.
Finally, the Hypotheca, Latin for “pledge,” let borrowers retain both ownership and possession while repaying debts.
The living-versus-dead pledge
Emperor Claudius brought Roman law and customs to Britain in A.D. 43. Over the next four centuries of Roman rule and the subsequent 600 years known as the Dark Ages, the British adopted another Latin term for a pledge of security or collateral for loans: Vadium.
If given as collateral for a loan, real estate could be offered as “Vivum Vadium.” The literal translation of this term is “living pledge.” Land would be temporarily pledged to the lender who used it to generate income to pay off the debt. Once the lender had collected enough income to cover the debt and some interest, the land would revert back to the borrower.
With the alternative, the “Mortuum Vadium” or “dead pledge,” land was pledged to the lender until the borrower could fully repay the debt. It was, essentially, an interest-only loan with full principal payment from the borrower required at a future date. When the lender demanded repayment, the borrower had to pay off the loan or lose the land.
Lenders would keep proceeds from the land, be it income from farming, selling timber or renting the property for housing. In effect, the land was dead to the debtor during the term of the loan because it provided no benefit to the borrower.
Establishing rights of borrowers
Unlike today’s mortgages, which are usually due within 15 or 30 years, English loans in the 11th-16th centuries were unpredictable. Lenders could demand repayment at any time. If borrowers couldn’t comply, lenders could seek a court order, and the land would be forfeited by the borrower to the lender.
This new right allowed borrowers to pay off debts, even after default.
The official end of the period to redeem the property was called foreclosure, which is derived from an Old French word that means “to shut out.” Today, foreclosure is a legal process in which lenders to take possession of property used as collateral for a loan.
Early US housing history
But eventually, U.S. financial institutions were offering mortgages.
Before 1930, they were small – generally amounting to at most half of a home’s market value.
These loans were generally short-term, maturing in under 10 years, with payments due only twice a year. Borrowers either paid nothing toward the principal at all or made a few such payments before maturity.
Borrowers would have to refinance loans if they couldn’t pay them off.
Rescuing the housing market
The federal government responded by establishing new agencies to stabilize the housing market.
Another new agency, the Home Owners’ Loan Corp., established in 1933, bought defaulted short-term, semiannual, interest-only mortgages and transformed them into new long-term loans lasting 15 years.
Payments were monthly and self-amortizing – covering both principal and interest. They were also fixed-rate, remaining steady for the life of the mortgage. Initially they skewed more heavily toward interest and later defrayed more principal. The corporation made new loans for three years, tending to them until it closed in 1951. It pioneered long-term mortgages in the U.S.
In 1938 Congress established the Federal National Mortgage Association, better known as Fannie Mae. This government-sponsored enterprise made fixed-rate long-term mortgage loans viable through a process called securitization – selling debt to investors and using the proceeds to purchase these long-term mortgage loans from banks. This process reduced risks for banks and encouraged long-term mortgage lending.
Fixed- versus adjustable-rate mortgages
After World War II, Congress authorized the Federal Housing Administration to insure 30-year loans on new construction and, a few years later, purchases of existing homes. But then, the credit crunch of 1966 and the years of high inflation that followed made adjustable-rate mortgages more popular.
Known as ARMs, these mortgages have stable rates for only a few years. Typically, the initial rate is significantly lower than it would be for 15- or 30-year fixed-rate mortgages. Once that initial period ends, interest rates on ARMs get adjusted up or down annually – along with monthly payments to lenders.
Unlike the rest of the world, where ARMs prevail, Americans still prefer the 30-year fixed-rate mortgage.
But as interest rates rise, demand for ARMs is growing again. If the Federal Reserve fails to slow inflation and interest rates continue to climb, unfortunately for some ARM borrowers, the term “dead pledge” may live up to its name.