Are Small Down Payments Disappearing?

Mortgages with small down payments are vanishing. Starting this month, Fannie Mae will no longer purchase conventional mortgages from local lenders with less than five percent down, a move which echoes a similar step taken by Freddie Mac some time ago.

The good news is that FHA mortgages and VA loans remain available with little or nothing down. Also, some lenders continue to make "portfolio" loans that require down payments of less than five percent. Indeed, there is some 100 percent financing out there from portfolio lenders -- "portfolio" mortgages are loans which lenders keep. Because portfolio loans are not being sold to investors the originating lender can establish whatever underwriting standards they prefer, including little or nothing down.

But are Fannie Mae and Freddie Mac on the right track? Why is it that they no longer want to buy mortgages that feature small down payments?

Are Smaller Down Payments Really Risky?

One reason to justify smaller down payments might be less risk, the idea being that a bigger down payment means added protection for those who buy mortgages. This sounds logical but in fact it's a questionable idea.

Writing for the Urban Institute, Laurie Goodman and Taz George explain that "if the intent was to reduce risk, this was a crude way to accomplish it." They say mortgages with between three percent and five percent down actually have lower default rates than financing with five-to-ten percent down

Goodman and George are not the only ones who have noticed that a small down payment does not necessarily mean more risk. The VA, as one example, offers loans with nothing down -- and VA loans according to the Mortgage Bankers Association have a lower foreclosure inventory rate than prime mortgages. The FHA, as another example, has been hugely profitable since 2010 and currently has $48 billion in cash on hand. Generally, you can get an FHA loan with 3.5 percent down.

At this point someone will invariably say that Fannie Mae and Freddie Mac have been forced to adopt the new down payment limits because of Wall Street Reform, the Dodd-Frank legislation. In fact, such claims are simply untrue. According to FDIC spokesman Greg Hernandez, the new qualified mortgage rules have no down payment requirement.

Market Impact

Not only are the Fannie Mae and Freddie Mac down payment policies difficult to justify in terms of risk elimination, they do little to strengthen real estate markets.

To have rising real estate values, there must be new people entering the marketplace each year. You need first-time buyers because they purchase homes and owners of the sold properties can then buy replacement properties, maybe a bigger house or a home somewhere else. Alternatively, if you do not have lots of new people entering the market, home sales stagnate and prices fall.

A new study of buyers and sellers just published by the National Association of Realtors shows that among first-timers the cash brought to closing was typically five percent. First-time buyers represent 38 percent of the marketplace, so if the median down payment was five percent it means that roughly half of all first-time purchasers bought with less than five percent cash up front.

How did first-timers get financing with less than five percent down? NAR says 39 percent used FHA mortgages while eight percent obtained a VA loan.

If roughly half of all first-time buyers purchase with less than five percent -- and if first-time purchasers are 38 percent of all buyers -- then half of 38 percent represents 18 percent of the entire marketplace. It's likely that a lot of those who buy with less than five percent down would not be in the marketplace unless financing with little down was available. Seen the other way, a lot of owners would be unable to sell if buyers did not have easy access to mortgage financing which requires five percent down or less.

The bottom line is that if you want to buy with little down there are good financing options out there. FHA, VA and portfolio loans are available nationwide with little or nothing down, financing that keeps the real estate marketplace active and growing -- and with little risk to the financial system.

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