Saturday, August 9, 2008

The Risks & Disadvantages of Low Down Payment Mortgages

Low down payment home mortgages expose buyers to more risk than many realize; high leverage substantially increases the risk of bankruptcy. This post explains leverage, and the impact that leverage has on 3-5% down payment mortgages. As a result, potential homebuyers with limited understanding of home mortgages will be more aware of the risks.

As in an earlier post, we are looking at a homebuyer purchasing a $100,000 home. He purchases the home with a 3% ($3,000) down payment, and takes a $97,000 mortgage. For this post, in order to simplify the analysis, let’s assume that it is an interest-only loan. Please note that we are assuming an interest-only mortgage only to eliminate the impact of the principal payments included in normal monthly mortgage payments. In the real world, an interest-only mortgage would generally not be advisable in this situation.

The Risk of 3% - 5% Down Payment Mortgages Can Be High Even in a Rising Market

A 5% Increase in Home Value
Home ValueBuyer's Equity
In 2 Years$105000$8000
At Closing$100000$3000
Change in $$5000$5000
Change in %5.0%166.7%

First, let’s look again at the impact of
a $5,000 increase in the value of the home over a two year period. As you can see above, a $5,000 increase in the value of the house results in a $5,000 increase in the homeowner’s equity as well. In the “Home Value” column, this is a $5,000 increase on a $100,000 investment – or a 5% increase ($5,000 / $100,000 x 100). However, in the “Buyer’s Equity” column, this is a $5,000 increase on a $3,000 investment – a 166.7% increase! ($5,000 / $3,000 x 100). The homeowner’s percentage increase is (166.7% / 5% =) 33.3 times as great as the increase in the underlying property. That’s leverage. This leverage originates from the fact that the value of the house is ($100,000 / $3,000=) 33.3 times the down payment. As a result, changes in the value of the home will be leveraged 33.3 to 1. To put this performance in perspective, it’s worth observing that a $3,000 5% Certificate of Deposit (CD), if you could find one, would take over 20 years to grow to $8,000.

However, let me point out that even though the homeowner’s equity has appreciated dramatically, he still may not be in position to realize a profit on the sale of the house. Total selling-related costs (closing costs, etc.) can be in the neighborhood of 10% of the selling price. If for some reason this buyer had to sell at this point, his $8,000 in equity would not cover $10,000 in selling-related costs. The result could be bankruptcy. (Note: In the original paper’s "rising market" case, the buyer had $10,000 in equity at the end of year two -- the $8,000 above, plus $2,000 in additional equity as the result of principal payments included in the 24 monthly mortgage payments made during the two year period.)

Leverage From a Small Down Payment Can be Devastating in a Declining Housing Market

A 5% Decrease in Home Value
Home ValueBuyer's Equity
In 2 Years$95000-$2000
At Closing$100000$3000
Change in $-$5000-$5000
Change in %-5.0% -166.7%

As you can see from the first example, leverage gives the buyer the opportunity for gains significantly larger than the increase in price in the underlying property. However, unfortunately, leverage works both ways. The table above depicts the impact of a $5,000 decrease in value. Again, the dollar change is the same in the “Home Value” column and the “Buyer’s Equity” column. However, in this case, a relatively small 5% decrease in the value of the home results in a quite large 167% decrease in the homeowner’s equity. As in our first example, the leverage magnifies the size of the move, when measured in percentages, by about 33 times.

Now the homeowner is “under water.” All of his equity in the home has been lost, and he now has negative equity (-$2.000). This means that in order sell the house, at the market price of $95,000, he will have to find an additional $2,000 to pay off the $97,000 mortgage. That’s over and above the roughly $10,000 he may still need to pay in selling-related costs. Remember, this buyer probably had to scrape to come up with the original $3,000 down payment. The small down payment has allowed him to become a homeowner when he otherwise would not have been able to – at least not at that time. The unintended consequence is that he has significantly increased his risk of bankruptcy. As they say, there is no such thing as a free lunch.

A 10% Decrease in Home Value
Home ValueBuyer's Equity
In 2 Years$90000-$7000
At Closing$100000$3000
Change in $-$10000-$10000
Change in %-10.0%-333.3%

What if instead of a 5% decline there is a 10% decline? The 33+ to 1 ratio still holds. Now a 10% decline in the value of the house translates into a 333%+ decline in the homeowner’s equity. The homeowner has lost more than three times his original investment ($3,000 in equity has declined by $10,000)! Do I need to point out that prices can sometimes decline even more than 10%?

Advantage of Large Down Payments: The Risk of 10% - 20% Down Mortgages is Significantly Less

Some people seem to think that "large" down payments protect the lenders. That’s true. However, it’s not the whole truth. Large down payments protect the buyer as well -- especially if he wants to, or has to, sell in the early years of the mortgage, before he has accumulated significant equity through his monthly payments. In particular:
  • A 10% down payment on a mortgage protects the buyer by helping to assure that he has enough equity to cover closing costs if he has to sell, assuming there has been no downturn in the market.
  • A 20% down payment on a mortgage will generally provide that same protection even if there has been a 10% decline in the price of the home. As you know, for some buyers in today’s market that was still not enough protection to avoid bankruptcy.
In times of financial difficulty, homeowners with substantial equity have options. If necessary, they can sell their homes and reduce their monthly expenses. If their home equity is large enough, it can even provide funds to tide them over until their financial situation improves. These options are largely unavailable to those with little or no equity in their homes. In those cases, in times of financial difficulty, owning the home actually makes the situation worse. The home represents an obligation that they cannot get rid of since selling the home could push them into bankruptcy. It’s a Catch-22: They can’t afford the home; but they also can’t afford to sell it.

Small down payments have both advantages and disadvantages. The advantages are well publicized and understood. My purpose here was to give “equal time” to the risks. Increasing leverage increases the risk -- especially the risk of bankruptcy in situations where the buyer is forced to sell in the early years of the mortgage (for example, because of a job move, illness or divorce). Forewarned is forearmed.

Related Materials

For a more complete discussion of the risks of homeownership, see The Risks & Disadvantages of Buying a House.
Planning to Buy a House Calculator: an interactive Excel calculator to help you calculate your mortgage payments and estimate the total cost of home ownership.
New Evidence on the Foreclosure Crisis from the WSJ: "Zero money down, not subprime loans, led to the mortgage meltdown."
Homeownership: America's Dream? Policy brief from the National Poverty Center
The Subprime Mess: The Problem With Small Down Payments: the "earlier post" mentioned in the intro of this post.
For lists of other posts, by category, see the drop down list (mobile viewers) or tabs (computer viewers) just below the blog header at the top of the page. Some viewers can also access the sidebar.

The picture is from Public Domain Pictures.
Copyright © 2008     Last modified: 8/14/2020

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