The mortgage authorities are at it again – resurrecting the 3% down payment mortgage. But just because it’s out there and being offered doesn’t mean you should take it.
How the 3% Down Payment Mortgage 2016 Edition Works
The news of the return of the 3% down payment mortgage, or 97% conventional mortgage, was announced this week on National Mortgage News in their article B of A Teams with Freddie, Credit Union to Offer Low Down Payment Mortgage.
Here are the highlights of the program:
- This rendition of the program is being brought to us by a combination of Freddie Mac, Bank of America, and Self-Help Credit Union, which is a non-profit community development lender
- Unlike pre-2008 editions, the borrower will not be required to pay for private mortgage insurance (PMI) on the loan
- Instead of PMI, Self-Help CU will take a first loss position on the loans through its venture fund
- Bank of America will originate loans under the program, but will not retain any risk on the loans
- Loans will be serviced by Self-Help Credit Union
- The program will be available only to borrowers with incomes that are less than 100% of the area’s median income – the US median income for 2014 is $53,657 (2015 won’t be released until September, 2016), but local median income figures can vary substantially from the national number
- $300 million have been allocated to the program in the first year, with the expectation of providing mortgages for 3,000 homebuyers
- Homebuyer counseling will be required for participation, which is usually the case with mortgage giveaway programs
- The absence of borrower paid PMI will make monthly payments more affordable
- Minimum FICO score requirement is 660
- Maximum debt-to-income ratio (DTI) is 43% (proposed housing payment plus recurring monthly debt, divided by your stable monthly income)
- Maximum loan amount is $417,000 (the “conforming” mortgage loan limit)
- Secondary financing is permitted, opening the door to zero down payment loans, a.k.a., 100% financing
- No borrower reserves will be required (the typical requirement is that borrowers have a minimum in liquid reserves equal to two months of the new house payment)
- Self-Help Credit Union originated 50,000 low- and moderate-income home loans prior to 2008 when the financial meltdown hit, and Fannie Mae and Freddie Mac were put into conservatorship
Having worked in the mortgage industry from 1993 through 2008 – when all of these mortgage giveaway programs were being rolled out under the auspices of complying with the Community Reinvestment Act – I can tell you this program is an awful lot like pre-2008 editions.
Those programs – or more specifically, the borrowers who took them – went down in flames. We have every reason to suspect the same outcome with this go-round.
Even Though It didn’t Work the Last Time They’re Still Bringing it Back
We all know how the pre-2008 housing bubble ended up. Millions of people lost their homes to foreclosure, and millions more were stuck in their homes, unable sell or refinance because property values had fallen below the outstanding mortgage balances.
We can write that off to what some would like to believe to be a one-time economic decline that sunk all boats. But even if we do, we can’t ignore the fact that the entire crisis was aided and abetted by 97% and 100% mortgage loans. They were enabling people who couldn’t afford to buy houses to buy them anyway.
It’s beyond even debating that people who have zero equity in their homes are vulnerable to economic disruptions. In fact, 3% equity in a home is the equivalent of negative equity. And if you want to take a low down payment mortgage, negative equity is a reality that you better be prepared to own.
Here’s why. In the mortgage industry it’s generally assumed that it will cost approximately 10% of the sale price of a property in order to sell it. In 15 years in the mortgage business, I saw that percentage hold up time and again – notwithstanding more optimistic claims from home sellers and especially from real estate agents.
But it’s simple math. If it costs you 6% for a real estate commission, 3% to contribute toward the buyer’s closing costs, and 1% to cover transfer taxes and your own seller closing costs, you’re right at 10%.
What this means, if you take a 97% mortgage, is that you will be instantaneously underwater on your mortgage by 7% as soon as you close on the home. This is because the net value of your home after selling expenses is just 90%, but your mortgage is equal to 97%.
The situation is made worse if property values in your area decline even by a little bit. A 5% reduction in the value of your property could lock you into your home for a very long time.
This describes the circumstances of millions of homeowners circa 2008.
3% Down Payment Mortgages Aren’t For Your Benefit – Got It?
Most people, I think, believe the standard narrative that low down payment mortgages are for the purpose of enabling people with slim resources to own a home. That certainly sounds emotionally comforting from a public relations standpoint, but it’s hardly the real reason why low down payment mortgages are offered.
The primary purpose is to juice the housing market. No, your local bank, Fannie Mae, Freddie Mac, and your kindly Uncle Sam aren’t really interested in showing us how much they love us. But all are interested in making sure that a high number of housing units turnover every year. Jobs, salaries, commissions, departments, agencies and political careers depend on those high numbers.
No, it’s not about you – it’s about macroeconomics. You know, unemployment, trade deficits, auto sales volume, housing starts, new construction – all are somehow influenced by how many houses are sold in a given year.
And one way to sell more houses is to make home financing more affordable and accessible. That involves lowering credit standards, relaxing income requirements, offering homebuyer tax credits, and providing low- and no-down payment mortgages.
And here’s something else that I’ve learned over the years – the mortgage gods tend to step up the availability of giveaway programs late in an economic cycle. Aware that the current housing upswing is getting tired, they introduce programs designed to stimulate housing sales, to keep the party going longer.
But what they are really doing is bringing future home sales forward into the present. For example, low down payment mortgages mean that a person doesn’t have to save up as much money for a down payment. That means you can buy a house this year, rather than two or three years from now.
The problem is who will be around the buy a house in two or three years after everybody already has one? We got the answer to that question in 2008 and the years that followed.
What’s at Stake For Anyone Who Takes a 3% Down Payment Mortgage
We all know what happened with housing in 2008 and beyond. You may know of people who experienced a hellish mortgage situation, or perhaps you went through one yourself. If so, then you know why anyone should avoid taking a 3% down payment mortgage.
Let’s take a look at the practical reasons why you shouldn’t:
- If you can’t do any better than a 3% down payment, you’re probably not ready to buy a house yet.
- Homeownership is more than making a monthly payment (but real estate agents won’t tell you that); you will have to fix whatever breaks in the house, and that will cost more money. For example, it can cost more to put a new roof on a house than a 3% down payment.
- As described above, a 3% down payment mortgage will put you instantaneously into a negative equity position
- Should you lose your job, and need to relocate for a new one, the negative equity may keep you from being able to move.
- The same negative equity may limit your ability to refinance the mortgage.
- If you need to borrow something close to 100% of the purchase price of the house, you don’t really own the house, the mortgage lender does. You are actually a renter in the sense that you are paying monthly rent (interest) on the money that you borrowed to acquire the home.
- No matter how you look at it, a 3% down payment will put you into a very precarious financial position – “precarious” being defined as having few options – why would you do that to yourself voluntarily?
There’s one other point that I want to raise that has to do primarily with perception. A lot of people are very impressed when a lender tells them that they can “afford” something. What that really means is that they fit the criteria to qualify for a certain loan.
But qualifying for a loan doesn’t necessarily mean you can really afford the house. As an example, with a 3% down payment mortgage, the program will allow you to qualify with a DTI of up to 43% – up to 43% of your income can go to paying for the new house payment, plus all of your recurring non-housing debt.
But as a lot of homeowners found out in the financial meltdown, once you add income taxes, life and health insurance, utilities, food and gasoline, and a dozen other expenses to your budget, a 43% DTI could easily turn into something over 100%.
The fact that a lender doesn’t count certain expenses against your income to qualify you for a mortgage doesn’t mean those expenses don’t exist. And it’ll be on you to pay them, not the lender.
A 97% mortgage will enable you to qualify for a larger loan based on the loan criteria. But it will not improve your ability to afford a house payment, especially when you add the variable costs of housing into the equation.
One more point…I like to take topics to their logical extremes, so let’s look as to some numbers at the upper range of the spectrum. The program will allow you to take a mortgage of up to $417,000; that means you can purchase a house for up to about $430,000. But turning that around, it also means that you will owe $417,000 on a house worth $430,000. Those are some pretty ugly numbers, especially the mortgage amount.
And what about the monthly payment on $417,000? Try $1,991 per month (assuming a 4% rate of interest), and that doesn’t include property taxes, homeowners insurance and any homeowners association fees. Can you afford a monthly payment of well over $2,000 per month, if you could barely raise $13,000 to make the down payment on the house?
These are good questions to ask yourself before diving into a loan program like this.
The Better Path
In the last section I made the point that renting the money to purchase a house with close to 100% financing is still renting – except that the rent is paid to the bank, rather than to a landlord.
But the truth is that even that comparison is not equal. If you have to use a 3% down payment mortgage, you may be better off continuing to rent your home or apartment. This is because renting is a more honest arrangement – honest in the sense that you as the tenant have limited liability regarding the property.
As an owner (who rents the money to own the property) you have essentially unlimited liability. If anything breaks you have to fix it. All routine maintenance to the property must be performed and paid for by you. If you have to move, you will have to sell the property and that can take a very long time, especially in a bad housing market. Or you may have to write a check at the closing table in order to sell the house, due to negative equity (which is a lot like making the REAL down payment on the sale of the home, rather than at purchase).
Perhaps even more important, the fact that you may have to resort to a low down payment mortgage means you are probably light on savings. If that’s the case, you will probably be better served by staying in your current rental situation and saving more money. You should not only want to make a larger down payment – to preserve your options and to protect yourself against swings in property value – but also so that you’ll have plenty of money to cover the full cost of homeownership (repairs, etc.).
Just because a program rolls out that looks attractive doesn’t mean that it’s the right choice for you. Forget about the bells and whistles attached to easy financing programs, and concentrate on making sure that you have a fundamentally strong financial position before taking on the responsibility of owning a home.