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Under this type of financing, called the open-end mortgage, a homeowner can get the money to pay for his alterations from the holder of his original mortgage, and can pay for the alterations, not over the 3-year amortization maximum provided under FHA title I, but over the remaining term of his mortgage.
There are literally millions of homeowners today who cannot afford to adequately maintain, modernize, or add to their homes because the monthly payments on a title I loan for more than $1,000 are too steep.
As you know, $2,000 borrowed under title I would have to be paid back over a 3-year period at the rate of $63.80 a month. A typical homeowner may already be paying $57 a month on a $7,000 mortgage. Adding an additional payment of $63.80 would bring his monthly payment to over $120 a month.
This outsized payment is clearly out of the reach of the majority of the homeowners. Proof: In 1952, according to the latest Federal Reserve survey, 56 percent of all nonfarm homeowning families had incomes of less than $5,000 a year.
Thus needed property repairs and improvements are neglected or cut down, and the hard-pressed owner is obliged to settle for the cheapest materials and the most inadequate equipment available.
The new baby, quite often the third or fourth, is shoved into one or the other of the two bedrooms, and we have a classic beginning of blight. Frequently the owner in the lower-income bracket makes the needed modernization, finances it with short-term credit, overextends himself, and is forced into default. (And we have another classic beginning of blight.)
Two facts from the 1953 Federal Reserve survey on consumer finance statistically underline the statements above:
1. In 1952, 40 percent of the nonfarm homeowners did not spend a penny for home improvements or maintenance.
2. The average expenditure of the families who did make any expenditures for repairs and modernization was only $242 in 1952.
I do not mean to imply that FHA title I has not been a useful and effective instrument. It has, and it will continue to be. The homeowner who can afford it would be well advised: (1) to pay cash or, if not (2) to use short-term credit such as title I with a 9.7 percent interest. Title I costs the homeowner less in dollar outlay than a long-term amortized loan.
However, there is also a very real and continuing need in our economy for long-term realty credit that will enable the average American to own and keep up, without strapping himself, the most expensive purchase he is likely to make in his life.
How many of the millions of low- and middle-income families, who now own homes, could have bought them on the 3-year credit term prevalent in the twenties?
I believe we can all agree that FHA title I, together with the VA, have proved the most effective credit instruments ever devised. However, FHA, unlike VA, does not carry through to its logical conclusion the basic principle that has made it one of the bulwarks of a mass housing market-that there can be no mass consumption or mass production of housing without long-term credit.
FHA fails to provide adequate modernization credit for millions of low- and moderate-income families who bought FHA insured houses. It requires that architectural provision be made for a future third bedroom, but it closes its eyes to how the homeowner of modest means is to finance the third bedroom. Twothirds of the houses put up in 1947 and 1948 had two bedrooms. Incidentally, children born last year numbered almost a million. Third and fourth babies have been coming along in very large numbers. It is easy to see why these twobedroom homes are inadequate.
FHA is not the only institution that has not adequately provided for needed home modernization. Most of the institutions that make conventional amortized loans, with the exception of a group of progressive savings and loan associations and a sprinkling of savings banks, insurance companies, and commercial banks, are equally myopic.
So a no man's land exists in the home modernization credit field for many homeowners. And the home modernization market is in the same state, relatively, that the new house market was in prior to the advent of FHA and VA.
And yet all these years we have had at our disposal an easy and inexpensive means of enabling the homeowner of modest means to improve his property. It is the open-end mortgage or, in more legal parlance, the mortgage that provides for optional additional advances. In legal terms, the open-end mortgage is a
contract between a lender and a borrower providing that future borrowings after the original loan be secured by the original mortgage.
In less legal terms, it is a mortgage which contains a provision permitting the homeowner to borrow additional sums from his lender for the purpose of the repair, remodeling, or improvement of the house covered by the mortgage. The advances are secured by the original mortgage so that the trouble and expenses of refinancing the mortgage is eliminated. The sums advanced are normaly paid back over the remaining life of the mortgage, though the term of the mortgage is frequently extended instead. Usually the interest rate for the additional advance is the same as the original mortgage rate.
Many people are under the impression that the open-end mortgage permits the homeowner to reborrow only the money he has paid off on the mortgage. But this is not the case, as I shall explain later.
Let's take Homeowner Smith. He was foresighted enough to insist on an open-end mortgage when he borrowed $10,000 on his 2-bedroom house. At the time his third child was expected, his mortgage was paid down to $7,000. Smith went to his lender and asked if he could reborrow $2,000 for a new bedroom and pay the advance back over the balance of the life of the mortgage.
In just about every State in the Union, except Texas, if Smith had a mortgage with a progressive savings and loan association or with Prudential or National Life Insurance of Vermont, he could get his $2,000 advance without refinancing the mortgage.
The $2,000 spread over the 10-year life remaining on this mortgage would cost him $20.74 a month. I am assuming a 41⁄2 percent interest rate. If Smith financed it through a title I loan, it would cost him $63.80 a month.
If Smith had bought his house in 1948 with a 25-year mortgage, he still could get a $2,000 advance today, even though his mortgage had not been paid down $2,000-that is, providing his mortgage secured future advances up to a total stated amount. It could have read $12,000. (For example, the Kentucky statute provides that additional advances shall not exceed $2,000 in addition to the original amount loaned.)
The monthly cost to Smith under these circumstances would only be $12.66, since in effect he would be paying his $2,000 back over the balance of the life of the mortgage-in this case, 20 years.
Only about 20 percent of the open-end mortgages written today make express provision for open-ending beyond the original amount of the mortgage. Yet, legally there is little reason why this provision could not be generally adopted in just about every State in the Union.
It was William Levitt who first proposed this type of open-ending in 1946. He said then, “Today we have to tell our buyer, ‘If you want to improve your house next year by adding another bedroom, you will have to pay for the improvement with short-term credit at 9.6 percent interest.'
"If I had included the extra bedroom in the first place, FHA would have taken it into account in determining the size of the mortgage. But FHA won't take it into account if the third bedroom is added 2 days or 2 years after the transaction is completed.
"It would be a very helpful thing if we could get a mortgage which would let us say to our customers, 'We have arranged your financing so that when your income increases and you want to add value-increasing improvements, you can get the money quickly at low interest with 20 years to pay it back, even beyond the original total of the mortgage and even before you have created more equity by paying your mortgage down.'
While it is well known that VA permits additional advances under the mortgage, it is less well known that VA stands ready any time after the closing of the original loan to guarantee supplemental loans beyond the amount of the original mortgage, to cover improvements as well as repairs and maintenance. VA's approval will be given only to the original lender and only on condition that the veteran has indicated his ability to meet the extra obligation.
Since it obviously makes sense to the Smiths of the country, you may ask why the open-end mortgage is not more widely used. Actually, it is growing in use at the rate of $100 million a year. Last year one-half billion dollars' worth of this credit was advanced. Contrast this with its $34-million performance in 1943.
Here are the reasons why it is not as widely used as it could be:
1. Not enough consumers know about it. Not enough mortgage lenders know about it. And not enough dealers, realtors, builders, architects, and all the other people to whom America's homeowners turn for information know about it.
2. There is an awful lot of misinformation about its legality. Curiously enough, the laws of the land, as reflected in court decision and in the statutes, are far ahead of the thinking of most mortgage lenders. For with the possible exception of mortgages on homesteads in Texas, there is no legal doubt in the minds of many distinguished attorneys that a lender, anywhere in the United States, can readvance funds under a properly drawn instrument and have these funds secured by the original mortgage.
With your permission, Mr. Chairman, I shall leave with you a representative list of some of the lending institutions that have been making open-end mortgages for years. You will notice that just about every State in the Union is represented.1
The only problems arise in connection with the costs of making additional advances. If the costs of the title search in a community are reasonable, then no problem arises. If they are too costly, then lending institutions that are anxious to extend long-term credit for needed home repairs can, in the majority of States, ignore the title search because an additional advance in superior to intervening liens, without actual notice of other liens.
Frankly, I don't see why FHA needs to concern itself with the lien status, any more than VA does, because that rests entirely with the mortgagee.
FHA doesn't concern itself with the variation in title costs under its title II program.
The use of the open-end mortgage provision in insured mortgages would in no way after the responsibility of the mortgagee, in the event of foreclosure, to make available to FHA a satisfactory title in exchange for debentures.
3. It takes a long time to get lending institutions to accept change. The acceptance of new concepts in the especially rigid field of real property is a particularly slow process.
But the mortgage form (and the deed of trust which is its equivalent in many States) according to Herbert Colton, former Assistant General Counsel of FHA, does from time to time respond to the evolutionary process.
the FHA insured mortgage as the most striking example.
He points to
He says that public opinion following the real-estate collapse in the 1930's demanded new mortgage financing concepts to correct the glaring weaknesses inherent in short-term loans bearing a low percentage to value and supplemented by secondary loans. In response, FHA developed and pioneered a new mortgage form. Its practicality, soundness and even the constitutionality of FHA itself was questioned by some. Legal thinking, however, quickly conformed to public opinion.
(I might add that savings institutions which were forbidden by State law in the 1930's from making loans for more than 66% percent of value quickly effected statutory changes which made exceptions of guaranteed and insured loans. But not all institutions conformed quickly. It took one of America's major financial institutions 10 years to accept the new-fangled idea of FHA.)
Mr. Colton goes on to say: "The current intense interest in conservation and rehabilitation of residential property now points up the lack of a satisfactory legal instrument for facilitating that kind of work. The open end properly used, offers a flexible legal form well adapted to this purpose.'
4. Perhaps the greatest deterrent to progress in the past has been the expense of making advances in some of the larger metropolitan markets.
Nearly all of the legal confusion has arisen from trying to solve this problem. Here is how the problem arises.
Let us go back to Mr. Smith. He asks his mortgage lender for the $2,000 and the mortgage lender is quite willing to oblige, but he cannot let Mr. Smith have the advance unless it has the same first lien status as the original loan. The mortgagee, and quite properly so, has to satisfy his lawyer and his bank examiner that the homeowner has not put any subsequent lien on his house that might come between the first mortgage and the modernization advance. Otherwise, the lender would have a third deed of trust on his hands.
In other words, a title search and sometimes title insurance is required, and these procedures cost money.
It is no problem in most of the smaller communities of America, because attorneys' fees and abstract fees rarely run more than $15 or $20; even in such major markets as Chicago, Los Angeles, Minneapolis, or Cincinnati this is true.
1 See item 1 in references: List of Lending Institutions.
2 See item 2 in references: Reprint from House and Home, July 1953.
And in some of the high-cost areas, savings and loan associations either absorb some of the costs in order to keep the charges to the homeowner low, or they employ attorneys on a yearly basis to handle the bring-down search.
These institutions take an affidavit from the homeowner that there are no liens against the property. (This is done in States where the lending institution is convinced that the advance takes priority over intervening liens without notice.) These institutions operate, and very successfully, in a business risk basis. However, they personally know the homeowners with whom they do business and they also are in a position to readily determine the amount of equity each homeowner has.
Let's take a large metropolitan market where the cost of a search plus title insurance can be considerable-northern New Jersey, for instance. Here the search and insurance for a $1,000 advance can run as high as $100. Obviously. a homeowner would have to have a hole in his head before he would borrow $1,000 and pay $100 in fees.
To get around this situation, the New Jersey Savings & Loan League introduced an amendment to the Savings and Loan Act in the State legislature. As a result the Savings and Loan Act was amended, setting up a statutory open-end provision. Savings and loan associations were given permission to make additional advances up to $1,000 or the amount the principal had been reduced, whichever is the lesser, without a title search. The statute recites that:
"All persons who acquire any rights in or liens upon the mortgaged real estate subsequent to the recording of any association's mortgage should hold such rights and liens up to the additional loans."
Not to be outdone, the savings banks of New Jersey had the Savings Bank Act amended to provide advances up to $2,500. The ferment carried over into other States.
The Maryland statute was amended for all institutions, provided first lien statutes on advances for repairs, alterations, or improvements up to the original amount of the mortgage or $500, whichever is the lesser.
The North Dakota statute was amended to permit savings and loan associations to make advances for maintenance, repairs, or modernization up to the original amount of the mortgage or $2,500, whichever is the lesser.
In Massachusetts and New Hampshire, the amended statutes do not favor any particular class of mortgagor, but give or attempt to give first lien status for advances up to the original amount of the mortgage.
Actually, while the statutes passed to date do give partial relief to the homeowner, the net effect has been to hamper rather than help the program. Restricting advances to $500 or $1,000 defeats the real value of an open-end mortgage program. Obviously, these advances are too limited to help a homeowner who wants to undertake an extensive modernization program.
Restricting advances to the original amount of the mortgage will eliminate many of the 8 million families who bought houses after the war. Their mortgages, in most cases, have not been paid down enough.
Horace Russell, the outstanding authority on the open-end mortgage, believes that it would probably have been better to depend on the common law, which in nearly all States permits advances beyond the original amount of the mortgage, providing a maximum limit is spelled out in the mortgage. (The purpose of stating a specific amount: To put the world on notice.)
What a boon this would be to the millions of people who bought two-bedroom houses in the years after the war, and whose financial status has improved enough to afford the extra monthly payment a $1,000 to $3,000 home modernization would entail.
What, then, is the answer to reducing the cost of making additional advances in high-cost areas? Many attorneys, including Horace Russell, believe that in the majority of the States a title search isn't necessary. He says that in 31 States of the Union, those which by mortgage law or court decision follow the majority or California rule, no title search is necessary. Reason: The courts in those jurisdictions have ruled that an optional advance is superior to an intervening claim if the mortgagee had no actual notice or knowledge of the intervening lien. The only way for the priority of optional future advances to succumb to intervening liens is for the intervening lienor to prove that the mortgagee has actual notice or knowledge of the intervening lien at the time the advance was made.3
See item 3, p. 84, in references: Legal Bulletin.
Twelve States and the District of Columbia, according to Russell, probably follow the majority rule. However, because decisions are few, inconclusive, or incomplete in these States, and many times based on poorly drafted contracts, many prudent lenders will require a title search in the absence of a decision both clearly defined and directly in point, although an affidavit is usually relied upon where the advances are relatively small amounts.*
Four States, Illinois, Michigan, Ohio, and Pennsylvania follow the minority or Michigan rule, that the lien of an optional advance is inferior to subsequent incumbances, even though it is made without actual notice of the intervening interest. Therefore a title search is unavoidable.
Horace Russell contends that Texas follows the majority rule. He claims the law is well settled that property capable of being mortgaged may be made the subject of a valid open-end mortgage, and that optional future advances provided for therein, have full priority over subsequent liens whether such advances are made before or after attachment of the junior lien. However, he points out that a validly established homestead is incapable of being mortgaged in Texas, except for purchase money, taxes, work and material spent for improvement, and for improvement only when a lien consented to by a wife is given in the same manner as when selling or conveying a homestead. It would appear that an open-end form could be used for materials and work, but that in every instance when money is disbursed the association must purchase the vendor's lien, tax lien, or mechanic's lien, as the case may be, and advance no amount in excess of that actually used for proper purposes.
Now, while a great number of attorneys for local lending institutions in the 31 States subscribe to Horace Russell's view that a title search is not necessary, these attorneys (and they include some who like to wear both belts and suspenders) usually insist that the borrower sign an affidavit, swearing that there are no liens against the property and that he is still the owner. This is especially true if the client is an out-of-State institutional investor, who cannot hope to know each homeowner personally."
Here is their reasoning:
1. A person who was the original mortgagor but who has since sold the property might fraudulently seek an advance;
2. An intervening lienor may have notified an employee of a lending institiution in accordance with the law. But this employee may have failed to pass the information along to the mortgage officer, or the registered letter may have been misplaced.
So in the absence of court-tested statute, even though the common law is favorable, some lenders are going to insist on a search.
For these institutions, the problem then of the cost of a search is still with us. However, there are some very hopeful signs on the horizon. As the openend mortgage increases in popularity, more and more title companies are establishing very reasonable rate schedules for the search and the insurance. And the title companies are discovering that it is profitable business.
The pioneer in this movement is the Los Angeles Title & Trust Co., one of the largest of the west coast companies. In 1925 it established special rates to make possible inexpensive financing for home modernization. It charges $10 for a $1,000 advance (this includes search and insurance), $12.40 for a $2,000 advance, and $13.60 for a $3,000 advance.
The service is so popular that nearly all of the lenders in southern California use it even though the California law is very favorable.
Chicago Title & Trust Co. is another example of an enlightened institution. It literally enjoys a monopoly in the Chicago metropolitan area, because the city of Chicago's realty records were destroyed in the Chicago Fire, and the Chicago Title & Trust's vaults were fireproof. Yet this public-spirited company established a special schedule of its fees for open-end mortgage advances: $10 for the first $1,000, $15 for $2,500.
The City Title Insurance Co. of New York, one of the pioneers in this movement, will insure advances for any lender in the United States for $5 per $1,000— a minimum charge of $10. This company, working with the attorneys of Dime Savings Bank of Brooklyn, have even developed an insurable modification agreement that permits Dime Savings to open-end all of its $400 million portfolio of existing loans, even though they contain no open-end provision.'
See item 3 in references: pp. 84-85, Legal Bulletin.
See item 3 in references: p. 85, Legal Bulletin.
See item 3 in references: pp. 105-106, Legal Bulletin.
See item 4 in references: Reprint from House and Home, December 1952.