The Down Payment Reemerges

August 4, 2008, Revised October 20, 2008, November 22, 2011

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, see Locking the Mortgage Is Critical in a Volatile Market. The second is a tightening of underwriting requirements, with higher down payment requirements the centerpiece. That is the subject of this article.

What Is the Down Payment?

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% of value. See What Is the Down Payment?

A 20% down payment can also be described as a borrower having equity in the property of 20%. 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.

Why the Down Payment is So Important

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% of value and property value does not change, a 20% down payment fully protects a foreclosing lender against loss, but a 10% 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.

Down Payment Contrasted to Owner's Equity

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% a year. A home buyer who puts nothing down, after a year of 20% appreciation, has as much equity in his property as a buyer who put 20% 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 adjusted. Just as rising prices generate homeowner equity, falling prices destroy it. The most important change is that there are no zero-down loans anymore except VA loans, which are limited to veterans, and USDA loans, which are limited to low-income borrowers purchasing homes in rural areas.

Perhaps the most surprising thing is that the rise in requirements hasn't been larger, which can be attributed to the Federal programs. FHA loans remain available at 3% down and the maximum loan amounts, which vary by county, are much higher than they were a few years ago. They range from a low of $271,000 to a high of $425,000 in Pennsylvania, and to $729,000 in California. On loans sold to Fannie Mae and Freddie Mac, the general requirement is 5% down, and special community-based programs remain available with 3% down.

With nobody forecasting a quick end of house price declines, down payments of 3-5% don’t look like a lot of protection for the Federal agencies against future losses. On loans that are untouched by one of the agencies, you can expect a required down payment of 20%, and if your property is in what is considered a "soft market", it will be higher.

Saving For a Down Payment

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.

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