Friday, April 29, 2011

The Myth of the 20% Down Payment

I wanted to close this week by addressing an issue that I have seen commented upon repeatedly both by the left and the right on the topic of mortgage lending.  When Sheila Bair, FDIC chairwoman, announced the preliminary guidelines for the qualified residential mortgages, she stated that a 20% down payment has worked well for us in the past, so this should be the new standard for qualifying to purchase a home.  Since then, I have observed in blogs and writings from various commentators that there seems to be a general consensus that once upon a time only 20% down mortgages existed and the country was better off for it.  So I decided to do a little research of my own and today I want to debunk the myth of the 20% down payment.

My first source of information on this subject was my own parents.  I began my career in housing finance in 1998, and prior to that date I really did not pay any attention to the housing finance industry.  I think one reason God gives us parents is so that we have an immediate resource at hand for events that happened prior to our own experience.  My parents are actually pretty typical of most Americans their age.  My mother married my father the day after she graduated high school.  They purchased their first home in 1965.  They used his VA entitlement which he earned through having served in the U.S. Air force, and my mother recalls having to bring in "about $100.00" for closing costs.  Their first home cost $16,000.00, brand new from the the builder,  but since their combined income was only about $500.00 a month, a 20% down payment would have been prohibitively expensive.  (That same home is on the tax rolls today for over $100,000)  Their first house payment, escrowed for taxes and insurance, was just over $100.00 a month and my mother worried all the time about how they could afford something so expensive.

My parents lived in the home for 7 years, and then they decided they wanted to move their growing family out to the country.  In 1972 they purchased another home.  Since they had not sold their first home yet, my father sold his new Buick to get 10% down for the purchase of the $36,000 home.  They lived in that home for another 6 six years before moving across the state line to New Mexico.  By that time, having owned and sold two homes, they had acquired enough equity to have a 20% down payment plus money saved to renovate their home.  They had been married for 15 years and had six children.

My parents were excellent home owners.  They never had a late payment on any of their mortgages.  Even during the extremely difficult, financially stressful times when I was a teenager and a young adult, my parents never missed a mortgage payment.  They valued their home and made sure that the payment was made. However, if they had been required to make a 20% down payment to get that first home, they would not have been able to do so when they did.  They would have had to wait much longer and save money, which would have certainly meant a delay in homeownership and might have also meant a delay in starting a family.

An excellent study by Daniel K Fetter at Wellesley College published March 11, 2011, tracks the correlation between low down payment programs such as the VA loan guarantee program and the increase in homeownership.  His findings are very interesting.  In 1920, the average loan to value was 40 to50 percent of the purchase price.  Home ownership was limited to about 45% of the U.S. population.  From 1940 to 1960, homeownership increased from 44% of the population to 62% of the population.  Fetter studied U.S. born males age 18 and up and found that homeownership in this sector increased from 27 to 53%.  His study indicates "39% of the increase from men of age 26 and 26% of the increase for men of age 32 can be attributed to VA home loan benefits."  During the 20 years he studied, the VA required median down payment was about 9% while FHA had a median down payment of about 17%.  However, Fetter also foot notes his report that he has not studied second liens or more lenient terms offered by thrift institutions and Building and Loan Associations which also allowed for smaller down payments. By the 1960's, according to Fetter, homeownership for men in their early 30's had more than doubled. 

In 1977,  a survey of veterans of World War II and the Korean War reported that 3.233 million veterans would not have had enough down payment for their first home without a VA loan.  If you recall, the U.S. did not eliminate the draft until 1973, so most young men did serve in some branch of the U.S. military, either through the draft or through voluntary enlistment.

Of course, not everyone had VA, but a history of the housing markets shows that even those homebuyers who did not have VA entitlement still did not put down 20%.  The Savings and Loans of the 1970s and 1980 often financed homes at 10% to 15% down.  According to a study produced by the Kansas City Fed and published for the Economic Review September/October 1980 issue, "In sample surveys of homebuyers in 1977 and 1979, the U.S. League of Savings Associations, discovered a tendency for down payments to decline as a percentage of purchase price, both for repeat buyers and for first time buyers. The survey results indicate that the proportion of repeat buyers making down payments of less than 20% of the purchase price rose from 24% in 1977 to 39% in 1979.  A much larger share of first-time buyers--62%--made down payments of less than 20%  of the purchase price in 1979, up from 47% in 1977." 

According to a table in Fetter's study, by 1996 the median down payment for a home purchase in the United States was 14%.  According to the 2nd quarter housing conditions' market report by HUD published in August of 1994, FHA and VA loans together totalled about 17% of the market, and privately insured mortgages represented 13.5% of the market.  "Uninsured mortgages continue to dominate the market, with 69.8% of the value of new mortgages," and yet the median down payment for that time was 14%, indicating the trend of 10% to 15% down payments even among conventional mortgage products.  That same report says that in 1994, the median price for a "quality new construction home" was $153,000.

As I was discussing my parents' history of homeownership with them, my father reminded that me that when I was very small he had purchased a second home in the resort area of Ruidoso, New Mexico.  I remember going there once when I was about five years old and wading in the stream that ran beside the house.  I was intrigued at the memory of this "second home" and so I asked him how big a down payment he was required to make, and he replied, "Nothing."  Granted, it was a very small house, so I am sure that the loan was small too, but by anyone's standards it was still a second home.  Apparently, the lending institution just pulled a credit report and loaned him the full purchase price. (Since we only visited the house one time, my parents decided to sell it after a few months.)

Today, we have embraced a theory that a hefty downpayment makes a good homeowner. Sheila Bair and the FDIC may tell us smugly that 20% down was a good standard to use, but the real truth is that 20% down has never been attainable to most young couples starting out or first time home buyers.  And what Ms. Bair and the FDIC totally ignore is that up until now there has been no national, legal, federal standard for what a mortgage should be.  Lending guidelines were determined by the government agency guaranteeing the loan or by the lending institution making the loan.  As a result, lenders could be flexible, and they were. Over the last 70 years, Americans have consistently put less down payment than 20% on their homes even at a time when housing was much cheaper than it is today.  The whole idea that before 1994 everyone in the country had 20% equity in their home is a myth.

The idea that making a down payment makes a borrower responsible is also a myth. In the fall of 2008 our company did a loan for a young man who was buying his first home.  He had inherited a large sum of money from a family member, and he had chosen to purchase a new construction home and pay cash for all of the upgrades.  He financed $90,000 on a purchase of $160,000.  He was serving in the military and had plenty of income to comfortably make the payments on the $90,000 he was borrowing.  The loan was fully underwritten, qualifying him against his income. He and his wife appeared to be thrilled with their purchase.

Four months later I got a phone call from the lender.  The borrower had never made the first payment!  I called the real estate agent who had sold him the house, and the agent tracked down the borrower's wife.  (They had disconnected their email accounts and were refusing to answer the telephone.)  The borrower was still in the military and still earning the same pay that he had been earning prior to closing on the house.  He was simply refusing to make the payments on his home.  He was apparently somehow under the impression that the government would be taking over the job of making mortgage payments, and he was no longer responsible for paying for his house.  We tried repeatedly to reason with him, to explain to him that he would face foreclosure and a sheriff's sale if he did not make the payments and that he would lose not only the house but the large down payment he had made in securing it.  As far as I know, the house did finally go into foreclosure.  His large down payment meant only that the bank did not take a loss on the house--it did not inspire him to be committed to making his payments.

The FDIC, the Federal Reserve, the Consumer Financial Protection Bureau and all of the other existing and soon to be formed agencies that are writing mortgage guidelines need to take a long hard look at the history of lending in the United States.  By requiring excessive down payments, the government is cutting a lot of responsible home buyers out of the market and taking away their chance at the American dream.  But they are not necessarily guaranteeing that those fortunate enough to have the money for a large down payment will necessarily value their investment.

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