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.

        *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?