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March 6, 2000, Revised
November 20, 2006, December 21, 2006, February 23, 2007
100% mortgages are both a
strength and weakness of the US system. Most borrowers who are able to make
a down payment, should make a down payment, because the return on investment
is very high.
"Is the ability of
people to borrow without a down payment a strength of the US mortgage
system, or a weakness?"
Both. Some
families become successful home owners with the help of 100% loans who
otherwise would be denied the benefits of home ownership. Others, who
shouldn't be home owners, are enticed to try 100% loans and they fail,
at heavy cost to themselves and sometimes to their communities. Still a
third group can afford to make a down payment but elect not to for bad
reasons. Each of these groups will be discussed.
100% Mortgage
Success Stories
The shortness of this paragraph is not indicative of
small importance. I know there are many 100% mortgage success stories, I
just don't know how many or who they are. It is an unstudied phenomenon.
Mortgages
With No Down Payment Have High Default Rates
This has been a finding of every study of mortgage defaults that I
have ever seen. One reason is that home-owners who
borrow the full value of their property have less to protect should
economic adversity strike. If they lose their job, or if property values
decline temporarily, they lose less from a default than borrowers with
equity.
In addition, borrowers able to
accumulate a down payment demonstrate budgetary discipline and the ability
to plan ahead. People able to save money every month before they buy a
home, are much more likely to meet their monthly mortgage obligations
afterwards.
Why Do
Lenders Make 100% Loans?
When property values are rising, as they have been
with only short interruptions ever since World War II, the
impetus for default is weakened. Rising values create equity in houses
that were initially mortgaged to the hilt.
In recent years, lenders have also
become more confident in their ability to assess the willingness and
capacity of borrowers to repay their mortgages. Using credit scoring and
other tools, they judge that it is safe to give less weight to an
applicant's ability to accumulate a down payment.
Lenders protect themselves,
furthermore, by charging higher rates on 100% loans. The rate includes a
"risk premium" to cover the losses lenders expect from the
higher delinquencies and defaults on 100% loans.
Some
Borrowers Who Take 100% Loans Should Have Remained Renters
Just because a lender is willing
to offer a 100% loan doesn't mean that the potential borrower should take it.
The risk premiums protect lenders. Borrowers bear more of the costs of
their failure than the lenders, and sometimes their communities suffer as
well.
In a default, the borrower's costs
include not only loss of a home, but the costs of having to find
another one and all the disruptions that that typically
involves. Plus the borrower's credit rating goes into the tank. And if many
defaulters live in the same neighborhood, the neighborhood can also tank.
Some people are just not cut out to be
home-owners. If you could have written either letter below, you are one of
them.
"I hadn't been in my house 3
weeks when the hot water heater stopped working. Only then did I realize
that I hadn't been given the name of the superintendent…who do I see to
get it fixed?"
Responsibility is central to
ownership, but people who have learned to depend on others often find it a
difficult concept to grasp.
"…the man [who came to my
door said my roof would fall in if it wasn't replaced…it wouldn't cost
me any money for 3 months, and then just $250 a month…and now they tell
me I have to pay them $4500 or they'll take my house…I did sign a lot of
complicated papers that I know I shouldn't have…."
This home-owner has several
characteristics, any one of which can cause trouble for a home owner; in
combination, they will spell disaster every time. Among them:
*Deciding on repairs and
improvements based on a solicitation by a huckster.
*Failing to seek out competitive
bids.
*Assessing the cost based on the
monthly payment, ignoring the interest rate and fees included in the
loan amount.
*Signing documents that aren't
clearly understood.
Don't
Take a 100% Loan if You Can Make a Down Payment
"We are purchasing a
$400,000 home that we want to finance with a 30-year fixed-rate mortgage.
While we can more than afford the cost of a 20% down payment, I would prefer
to keep my money in my investments instead. I was thinking of
financing 100% (using an 80/20 to get out of paying PMI) but was unsure if
this type of loan structure would result in a higher interest rate on the
first mortgage?"
Taking a 100% loan with a piggyback – a first mortgage for 80% of
value and a second mortgage for 20% -- would result in a higher overall cost
than an 80% loan with a 20% down payment. In part, the higher cost will be
in the higher rate on the second mortgage. But in addition, either the rate
on the first mortgage will be higher, or the total loan fees will be higher.
To illustrate, on October 17, 2006 I shopped for a purchase loan on a
$400,000 property in California. If I put down 20%, I could get a 30-year
$320,000 FRM at 5.75%, ½ point, and other lender fees of $4770. If I went
100% and kept the first mortgage rate at 5.75%, the rate on the second
mortgage of $80,000 was 8.15%, total points were 1.5 and other fees were
$6490.
Your intent is to invest the $80,000 that would otherwise go into a
down payment. But a down payment is also an investment. The return consists
of the reduction in upfront costs, lower interest payments in the future,
and lower loan balances at the end of the period in which you expect to be
in the house. I calculated the annual rate of return on investment in the
case cited above, assuming you intended to be in the house for 7 years. It
was 15.6% before tax, and it carries no risk. Investments that good are not
available in the marketplace.
Why is the return so high? When you take a 100% loan, even though you
have the capacity to make a down payment, you place yourself in the same
risk class as borrowers who have not been able to save for a down payment,
and who have negative equity in their house the day they move in. The
default rate of such borrowers is relatively high, they pay for it in the
price of the piggyback (or in mortgage insurance), and you pay the same
price as them.
You wouldn’t have your 17-year old son purchase automobile insurance
for your car. You wouldn’t buy life insurance and tell the insurer you are
10 years older than you really are. You shouldn’t take a 100% mortgage loan
when you can afford to put 20% down.
The one possible exception is if the amount that would go into down
payment can be invested to earn a very high return. This is discussed in
Invest Xtra Cash in
Securities or Larger Down Payment?
Copyright Jack Guttentag
2007
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