Do Mortgage Down Payments Matter?

It was a big day for housing finance policy on Capitol Hill. This afternoon, House Republicans formally unveiled a group of bills meant to wind down mortgage giants Fannie Mae and Freddie Mac and to more broadly reform the government's role in the housing market. But before that occurred, the Senate held a hearing to consider housing finance policy alternatives in a Banking Committee hearing. It's currently lagging behind the House in drafting legislation. One question that was raised during the hearing is a particularly important one for mortgage finance reform: do down payments really matter?

If you had asked this question to mortgage bankers in 2005, you would have heard a chorus of voices praising the virtues of low or even no down payment mortgages. Most of those advocates for little or no money down have been silenced by the housing market's crash. A large number of those borrowers who provided little or no down payments have since defaulted on their loans.

But perhaps this is coincidental -- not causal? One of the committee's witnesses was Janneke Ratcliffe, senior fellow at the left-leaning Center for American Progress. She argued that low down payments have little correlation to defaults, and pointed to a study that her think tank performed to prove the point. She said:

In our particular study, where we compared the folks who had borrowed with low down payment loans with sustainable prime-priced 30-year fixed rate mortgages to purchase homes versus those in the subprime sector, the primary drivers of the difference in default was adjustable rate features, and broker channel, and prepayment penalties. So these are some of the features that we identified. Meanwhile, I think we've gotten to the point where somehow low down payment lending has become conflated with subprime, and I'm not sure that's justified.

This probably has something to do with the fact that so many of those new mortgage products also included low down payment options. One now infamous version was the option adjustable-rate mortgage, which could even result in negative amortization, wherein the mortgage principal could rise to more than 100% of the home's value. According to Ratcliffe, however, if you separate out the wacky mortgage products from the prime products, you find that low down payments are not a significant causal factor for default.

Arnold Kling, another witness who is a member of the free market-leaning Mercatus Center's Financial Markets Working Group at George Mason University, agreed that dangerous loan products should be done away with. He disagreed, however, that allowing low down payments is a safe practice. He said:

There is simply no way to make low down payment lending stable in any environment any than in a rising house price environment. [The Center of American Progress's] study says it covers the last decade. If you made a low down payment loan in 2001, there was enough of a price increase after that you're probably fine. But it only works in that environment and it creates this cycle of a boom as house prices are rising, and then once they stop rising everybody crashes. You get this epidemic of foreclosures. It destabilizes the entire market.

In a sense, both of these witnesses are right. In most times, when home prices are rising, low down payments turn out just fine. When a default occurs in this environment, a borrower can often just sell their home, even if with little equity. And if foreclosure is necessary, the bank will probably get almost all of its money back if home prices rose during the time the borrower lived in the home.

But when the music stops, and an economy sees home prices declining, low down payment mortgages can be extremely dangerous for two reasons.

First, if home prices are declining, then banks will incur much bigger losses on low down payment loans that default. If home prices have dropped 15% in the two years since a no down payment mortgage was originated, then suddenly the best-case scenario for the bank is a 15% loss. If that same loan had a 20% down payment instead, then the bank might be able to break even, or the borrower may have been able to simply sell the home. As a result, banks face much higher potential loss severity with low down payment loans. Moreover, since banks don't want to realize a big loss on a loan, they might also prolong the time it spends in housing inventory before accepting a bid to purchase, which will help to magnify the housing market's troubles as supply overwhelms demand.

Second, there's a psychological factor to consider that comes into play when home prices begin declining. If borrowers have put down, say 20%, equity from the beginning they will be less likely to simply walk away from their home. If their mortgage is just a little bit underwater at that point, then it's more likely that they'll want to keep their home by continuing to pay during the down market. But if borrowers have little or no equity in their home, then walking away is very attractive -- particularly if a home is far underwater. And their mortgage will be even deeper underwater in a declining home price environment if little or no down payment was initially provided.

Ultimately, the market should be able to decide which side is correct on this question, if the government gets out of the way. Fannie Mae and Freddie Mac provided guarantees for relatively low down payment loans over the years. But without their backstop, lenders can decide for themselves whether they're willing to take on the risk of a mortgage with little or no down payment. From what we've heard so far, it isn't likely that banks would generally be willing to accept mortgage default risk without borrowers coming up with a chunk of money upon purchase. If the market isn't willing to accept mortgage risk without a significant down payment, why should taxpayers?