Feb122018

How much should buyers put down to buy a home?

In order to provide a stable equity cushion for all homeowners, the minimum down payment should be at least 10%.

Repost from OC Housing News 2011-2016

The qualified mortgage standards provide a barrier against excessive risk taking in the secondary mortgage market. If mortgage-backed securities buyers lose their minds and start buying the same toxic garbage they coveted during the housing bubble, they must find an originating lender willing to underwrite that garbage and retain 5% of it on their own balance sheet. The 5% retention requirement generally kills the deal. This serves as an extra safeguard in the system, and it’s intended to prevent future housing bubbles.

I wrote that New mortgage regulations will prevent future housing bubbles. The housing bubble was inflated with interest-only and negative amortization loans and unrestricted debt-to-income ratios. With those products effectively banned, mathematically, it’s very difficult to inflate a housing bubble. The loan balances necessary to inflate prices can’t be underwritten without high debt-to-income ratios or non-amortizing loans.

In 2013 I lamented that Legislators failed to implement down payment requirements because the fact is that Large down payments provide stability to the housing market. But how large is too large?

Studies have shown that a 20% down payment has significantly lower delinquency rates than mortgages with lower down payments. But why is that? Mostly, it’s due to “skin in the game.”

People who’ve put down large down payments rarely default. In purely economics terms, people shouldn’t consider sunk costs like down payments in their decision making. However, homeowners do. People simply don’t walk away from properties where they’ve put a lot down, even if they’re deeply underwater. The decision is more emotional than logical, but coupled with the emotional desire to “own” these two forces prevent most people from strategic default even when that option is the best available to them.

There is no way to accurately measure how much skin in the game motivates people to stay and pay. Everyone knows it’s important, but with no way to accurately gauge how much is required, the forces demanding little or no down payment are winning — and for good reason — New down payment requirements could crash housing again.  Unfortunately, completely eliminating down payment requirements leaves us with borrowers putting no skin in the game, and quite frankly, that’s a horrible idea.

When legislators debated wether to implement a down payment requirement, they used an infuriating and transparent ruse to justify a 0% down payment requirement. The government chose to evaluate only two options: 30% down or 0% down. Even though it’s completely unprecedented, they chose to examine 30% down because they knew such a requirement made no sense. Since nobody advocates a 30% down payment requirement, that option wasn’t chosen, leaving us with a 0% down payment requirement.

What would have happened if they had proposed splitting the difference at 15% or even 10%? Well, that would have been a reasonable compromise with solid reasoning for its inclusion. Since the lobbyists didn’t want that to be a possibility, they put the red herring number of 30% out there to make it look as if they seriously considered a down payment requirement when in fact they killed it.

Nobody in the mainstream media picked up on this deception.

Why is 10% the appropriate minimum number?

In order for a borrower to have skin in the game from their first day of ownership onward, the market must be stable enough for prices to slowly rise, and the initial equity must exceed the liquidation costs if the borrower needed to sell.

If a borrower lost his or her job the day after closing escrow and couldn’t afford to make payments, they would have to put the property on the market and sell. Since the buyer was the most aggressive bidder on the property, they will need to discount the property to find a new buyer, perhaps 2%. Further, as a seller, they will have to pay various closing costs and fees which will cost another 2%. And last but not least, they will have to pay an agent to sell their house, so that’s another 6% gone. If you add those costs up, the total loss will be about 10% of the initial purchase price.

At any down payment level under 10%, the market is vulnerable to strategic default from underwater borrowers. At 10%, the market rests at its minimum level of safety. At 20%, which is what the down payment should be, the individual borrowers, and thereby the market, has a cushion in case of an economic calamity.

In short. 10% is good, 20% is better, 30% is a red herring, and 0% is dangerous. However, 0% provides the most opportunities for lenders to pursue business, so that’s what lobbyists pushed for, and that’s what we got.