Over the last 18 months, the mortgage market has changed more rapidly than in any comparable period since the Great Depression of the 1930s. From the standpoint of borrowers, two changes are of paramount importance. The first is an increase in day-to-day price volatility, which I wrote about a few weeks ago. The second is a tightening of underwriting requirements, with higher down-payment requirements the centerpiece. That is the subject of this article.

Underwriting requirements are the rules lenders impose to assure that loans will be paid off, and the down payment has always been the most important of them. The down payment is the difference between the lower of the sale price or property value, and the amount of the mortgage loan secured by the property. If you purchase a house for $200,000 that is appraised for $200,000 or more, and you take a mortgage of $160,000, your down payment is $40,000, or 20 percent of value.

A 20 percent down payment can also be described as a borrower having equity in the property of 20 percent. In the future, equity in the property is measured by the difference between the current value of the property and the current loan balance, both of which are likely to differ from their values at the time of purchase.

One reason the down payment is so important is that it is the single most important factor affecting loss to the lender. The down payment is a buffer against lender loss in the event of a foreclosure. For example, if foreclosure costs are 20 percent of value and property value does not change, a 20 percent down payment fully protects a foreclosing lender against loss, but a 10 percent down payment provides only partial protection.

Perhaps even more important, borrowers who get into payment difficulties but have equity in their properties usually will sell to avoid foreclosure. By selling, they realize the equity themselves whereas if they allow the property to go to foreclosure the equity will be partially or wholly depleted by foreclosure costs. Their selling avoids the foreclosure.

There is still another reason why lenders attach so much importance to the down payment. Borrowers who have been able to save the funds for a down payment are less likely to get into payment troubles later on. Saving for a down payment requires budgetary discipline; repaying a mortgage also requires budgetary discipline, and the one carries over to the other. Of course, this assumes that the down payment is saved, not borrowed. Underwriters look for evidence that the funds committed to down payment are the borrower’s own.

When a house is purchased, the owner’s equity is the down payment, but as time passes the equity is affected by two other things. One is any change in the loan balance. If the mortgage is "fully amortizing," the mortgage payment includes a principal component, which reduces the loan balance. If the required payment is interest-only and the borrower does not add anything to the payment, the loan balance will not change. And if it is a negative-amortization loan, the balance will increase rather than decrease, and homeowner equity will decline. In the first few years of a mortgage’s life, however, changes in homeowner equity resulting from changes in the loan balance are usually quite small.

Homeowner equity is also affected by changes in house prices, which can be sizeable. During 2000-2006, house prices in some metropolitan areas rose by more than 20 percent a year. A home buyer who puts nothing down after a year of 20 percent appreciation has as much equity in his property as a buyer who put 20 percent down in a stable market.

It is hardly surprising that house-price inflation during the go-go period resulted in a drastic weakening of underwriting requirements in general and down-payment requirements in particular. Zero-down loans became increasingly common during this period.

When the market turned and home prices began to decline in late-2006-2007, down-payment requirements had to be drastically revamped. Just as rising prices generate homeowner equity, falling prices destroy it. There are no zero-down loans anymore except VA loans for veterans. FHA loans remain available at 3 percent down for smaller loan amounts, but conventional loans now generally require 10 percent down, and in some areas it is higher. On top of this, lenders now want most borrowers to have good credit scores and to fully document their incomes.

It easily could be worse, and without the federal agencies (FHA, Fannie Mae and Freddie Mac) it surely would be. Nobody is forecasting a quick end of house-price declines, so down payments of 3-10 percent don’t look like a lot of protection against future losses. Any loan today that is untouched by one of the federal agencies will have a required down payment larger than 10 percent.

Down-payment requirements have a critical impact on the capacity of consumers to afford a house. If buying one is in your plans but you have never been able to save, it is time you learned how. The secret is to give saving high priority in your budget.

Decide beforehand what part of your income you can afford to save, and create a special account for that purpose. Then immediately after you are paid, write a check for deposit in that account. If you view saving as a residual — what remains of your income unspent at the end of the month — you are giving saving the lowest possible priority, which is a virtual guarantee of failure.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.


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