For home buyers, it’s the best and the worst of times. Lending rates hit another record low in the third week of May—an average of 3.8 percent on 30-year mortgages. But receiving that low interest requires buyers to actually get a loan—no easy feat now that banks have tightened their lending requirements. For many buyers, the down payment has become the toughest hurdle—traditional mortgage lenders like Bank of America and Wells Fargo are routinely asking them to put down 20 percent or more. A provision in the 2010 Dodd-Frank financial reform law also proposes a 20 percent down requirement for home buyers, and is currently under consideration by the Federal Reserve and six other agencies.
Some experts applaud banks for asking for higher up-front payments since it suggests they’re moving back to the sound lending of earlier years. Authors Gretchen Morgenson and Joshua Rosner of Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon argue that low down payments helped fuel the housing crisis in the first place and caused thousands of borrowers to own a home without having any equity in the property. “In just a few short years, all of the venerable rules governing the relationship between borrower and lender went out the window,” they write, “starting with the elimination of the requirements that a borrower put down a substantial amount of cash in a property….”
With the banks tightening their lending requirements, government-backed Federal Housing Administration (FHA) loans are becoming increasingly popular due to their low down payment requirement —3.5 percent—for qualified borrowers. Many argue that this is too low, could cause yet another housing bubble, and reduces the pool of borrowers that the banks can draw from.
But others say that large upfront payments could further depresses the housing market by pushing out the buyers who fall somewhere in between – those who don’t qualify for an FHA loan, but can’t afford to save 20 percent for a down payment. Focusing on the size of the down payment distracts from the real source of sound loans—better underwriting and eliminating alternative borrowing methods like interest-only and adjustable-rate mortgages, says former mortgage lender Colin Robertson, who runs the website The Truth About Mortgage. There’s no “just right” amount of up-front money, he says. The down payment is just one element of assessing risk. Good underwriting involves looking at the borrower’s credit and the debt-to-income ratio, he says—something that rarely happened during the housing crisis.
Historically, lower-income buyers who qualified for FHA and Veterans Administration (VA) loans have also been asked to make higher down payments than today. In 1950, for example, the average down payment on FHA and VA loans was 15 percent, according to a May 2012 paper by Paul Willen, senior economist and policy advisor at the Federal Reserve Bank of Boston, and two colleagues. Conventional bank loans required even higher down payments—37 percent in 1950, and 24.5 percent in 1967, according to the study. By 1967, down payments on FHA and VA loans had fallen to less than 5 percent. During the lending free for all of the 2000s, the average down payment for all first-time buyers had dipped to 4 percent.
The lower upfront payment on FHA and VA loans was a tradeoff that the government made to get more people into homes. By 1965, the homeownership rate was 63 percent, up from about 45 percent during the 1930s and 1940s, when buyers typically were required to make 50-percent down payments. Today, even with homeownership rates having dropped, 65 percent of Americans own the place they live.
Typically, low down payments coincide with more foreclosures. But even with low down payments, foreclosure rates were modest before the housing crash. Following World War II until 1985, foreclosure rates on FHA and VA loans were about 1 percent before rising to about 2 percent in 1999. Even in 2006, foreclosure rates on conventional loans were .5 percent and those on FHA and VA loans averaged only about 2.4 percent. “These were always relatively small numbers,” says Willen. It wasn’t until 2009 that foreclosure rates spiked to 3 percent and 4 percent respectively.
Roberto Quercia, director of the University of North Carolina’s Center for Community Capital, says his team’s research found that, if properly underwritten, conventional loans with small down payments can perform well. Their 2011 study looked at a demonstration program that provided 30-year fixed rate mortgages to qualified low-income borrowers with good credit track records and low debt levels, most of whom put down less than 5 percent. Ninety-five percent of those borrowers made their payments successfully, even during the years of the housing crisis, the researchers reported.
The problem that created the housing crisis, contends Quercia, wasn’t low down payments. It was that lenders introduced sloppy underwriting, did poor or no documentation, inflated appraisals, and sold loan products with high interest rates and nothing down.
But even if lender practices are sound, when home values drop, default rates rise as borrowers lose equity. And that’s why lenders are twisting the screws on down payments now, says Willen: “If you believe house prices are going up, then you’ll be very comfortable doing a low down payment loan.” The fact that banks are requiring more money down, he says, means bankers think the market could dip again.