Subprime Mess: The Problem With Low Down Payments

For the past year or more, we have experienced nearly unprecedented turmoil in the housing markets. Blame has been assigned to everyone from the buyers to the lenders to Wall Street and beyond. We are now in the process of taking corrective action. New laws and policies are being proposed seemingly every week with the goal of helping to resolve the current situation and avoiding a repeat occurrence. However, I am concerned that not enough attention is being paid to the role that down payments played in this whole process.

In the old days, the standard down payment on a home was 20%. Somewhere along the way this requirement has been reduced, in some cases to 5% or even lower. Granted, the down payment requirements are now on the increase. However, as best I can tell from the FHA web site, one can still get a mortgage with as little as 3% down.

Presumably, the objective of the lower down payment requirement is to facilitate home ownership – especially among those who may not be able to meet conventional loan requirements. But, is 3% down really a good idea for someone of limited financial means?

Suppose Joe buys a $100,000 home by putting $3,000 down and taking a $97,000 mortgage. Suppose further that during his first two years of home ownership the market is flat – a state of events that many of today’s sellers would gladly settle for. Let’s look at what happens if at that point he wants to sell. At closing he would be due $100,000, and would owe approximately $95,000 on his mortgage (I’m assuming a 6.5% mortgage), plus roughly $10,000 in closing & other costs. Unless he can come up with the additional $5,000 he can’t close. He can’t sell his house. If for some reason he HAS to sell, he’s in trouble and could end up in foreclosure. In fact, using my assumptions, it will be more than 5 years before Joe builds up enough equity to cover his selling costs without having to rely on price appreciation.

Now if the house appreciates during the first 2 years, he could be “home free”. For example, if the house appreciates 5% (not unheard of, but clearly not guaranteed), he sells it for $105,000, pays off the remaining $95,000 on his mortgage and has $10,000 left for closing and other expenses. That’s mainly due to the magic of leverage. His equity has increased from $3,000 to $10,000 in 2 years mainly because he is leveraged over 30 to 1. Note, however, that buying a new replacement house could still be a problem. He’ll need another down payment, plus closing & other costs of 5% or so, to do that.

However, what if there is a 5% decline instead? It could happen you know. This decline would completely wipe out his initial $3,000 in equity plus the $2,000 additional equity that he has accumulated during two years of payments. If he needs to sell, he now must come up with $10,000 for closing costs out of his own pocket. This is obviously likely to be a huge burden for someone who, two years before, had to scrape to come up with $3,000. Foreclosure would again be a distinct possibility.

When you allow people to buy homes with 3% down, you’re leveraging them more than 30-1. The more leverage, the more risk. Since we’re dealing with a population that is likely to be facing some financial challenges, and given the many possible reasons someone might be forced to move in the first five years, I have to ask…. Is this a good idea?? Are we really doing these borrowers a favor when we expose them to this much risk? Just asking….

Related Materials

Homeownership: America's Dream? Policy brief from the National Poverty Center
New Evidence on the Foreclosure Crisis from the WSJ. "Zero money down, not subprime loans, led to the mortgage meltdown."