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Mortgages requiring down payments smaller than 20 percent have never been more popular, especially among first-time buyers.
The median down payment by first-time buyers is now 6 percent. In today’s real estate markets, there probably wouldn’t be much of a first-time buyer business if it weren’t for the abundance of low down payment options.
Rising prices increase down payments. Higher down payments, coupled with poor savings habits, are making it very hard for millions of first-time buyers to save enough to buy a home.
A recent Urban Institute study found that more than 19 million millennials in the 31 largest metropolitan statistical areas (MSAs) have the credit and income to purchase a home but are still renting because they don’t have the down payment.
The hidden costs of a low down payment
Borrowers who use low down payment loans pay a price to do so. To protect themselves should their borrowers default, lenders require buyers to carry and pay for mortgage insurance until they acquire 20 percent equity, if they have an FHA mortgage, for the entire life of the loan.
However, most low down payment borrowers have no idea that their lenders are also charging them a premium interest rate or finding other ways to reduce their perceived risk.
Using a low down payment mortgage also increases the chances that a mortgage application won’t be approved because lenders use loan-to-value ratios (the ratio of the amount borrowed compared to the total cost of the house) as well as debt load, income and credit to make underwriting decisions.
Risk-based pricing works if it only reduces the lender’s exposure to default. New research by economists at the JP Morgan Chase Institute led by Institute President Dana Farrell suggests that higher down payments may increase defaults because they decrease homeowners’ liquidity (access to cash) and thus their ability to withstand financial stress.
From an analysis of Chase customers, the researchers found that homeowners with less than one month’s post-closing cash defaulted at least five times more often than borrowers with just three mortgage payments of post-closing cash, regardless of the homeowner’s equity, income level or payment burden.
“Contrary to the conventional wisdom that larger down payments, and therefore lower loan-to-value (LTV) ratios, reduce default rates, a program allowing homeowners to maintain a higher level of liquidity by providing a slightly smaller down payment at origination and keeping the residual cash in a reserve account for use in the case of financial distress, may lead to lower default rates, the researchers said.
The researchers suggested that lenders test their hypothesis through a pilot program for a sample of mortgage applicants who, according to conventional underwriting standards, have a higher risk of default, such as those who have lower credit scores and make small down payments.
“If the strategy based on maintaining a minimum amount of post-closing liquidity in an emergency mortgage reserve account is impactful and cost-effective, it may be a better approach to default prevention than underwriting standards based on meeting a total debt-to-income threshold at origination,” the Chase Institute study concluded.
What you should pay for a down payment depends on your financial goals
For first-time buyers, mortgage expert Dan Green says, “It’s not always better to put a large down payment on a house. When it comes to making a down payment, the choice should depend on your own financial goals. It’s better to put 20 percent down if you want the lowest possible interest rate and monthly payment. But if you want to get into a house now, and start building equity, it may be better to buy with a smaller down payment — say 5 to 10 percent down.”
These findings are the just the beginning of the process of potentially changing the way we think about risk and mortgages by looking at the results of our current approach. The process is complicated.
Every player with a financial interest in mortgage risk must change their minds. This includes a wide range of players — lenders, the GSEs who buy their mortgages to securitize them, mortgage insurers, the investors who buy mortgage-backed securities, the ratings agencies that review them and the government agencies that oversee the entire process.
Steve Cook is the editor of the Down Payment Report published by Down Payment Resource.