Residential Magazine

Balancing Risk

Rethink long-held beliefs about low-downpayment borrowers

By Rob Chrane

Many lenders that stepped back from low-downpayment lending at the outset of the pandemic did so reluctantly. With massive unemployment and economic recession looming, and 4.7 million mortgages in forbearance, these lenders and the originators who work with them took the steps they thought necessary to reduce risk — and any perceptions of risk.

With thousands of high loan-to-value (LTV) options available, many first-time buyers found other sources to fund their first home purchase. In fact, the share of first-time homebuyers increased during the pandemic, rising to 35% of all buyers in June 2020, higher than the 29% to 32% average since 2012, according to the National Association of Realtors. 

The share of buyers who put down less than 20% reached 77% in June, exceeding the pre-pandemic level. Do the more than 2,000 federal, state, local and nonprofit downpayment-assistance programs that picked up the slack expect increased levels of delinquencies and defaults after originating or guaranteeing loans with downpayments of less than 20%? 

Since the Great Recession, when low- and no-downpayment loans were sold to buyers regardless of their credit, income or debt, the Dodd-Frank Act and other reforms, such as a Federal Housing Administration (FHA) prohibition against seller financing, have lowered delinquency and default rates for loans with LTVs higher than 80%. Since then, studies by leading housing economists have helped explain the levels of risk involved with higher LTVs. These findings have helped lenders design loan products that pose less risk or no additional risk when compared to traditional loans. 

Innovative research

Among the key findings of these studies is that downpayment assistance, including programs from a governmental or community organization, is unrelated to default risk. A 2019 study for the Federal Reserve Bank of St. Louis analyzed a sample of low- and middle-income FHA borrowers, and found that downpayment assistance is not significantly associated with default risk. 

Michael Stegman, an author of the study and a senior research fellow in the Center for Household Financial Stability at the St. Louis Fed, said the analysis looked at various downpayment sources, including downpayment-assistance programs, family and friends, government programs and other secondary financing sources. It uncovered different utilization rates of these sources by race and ethnicity. 

The analysis showed that — when controlling for all other borrower characteristics, as well as lateral and market characteristics — downpayment assistance does not create an incremental default risk beyond that of any other factors. If a significant number of FHA borrowers with government downpayment assistance pose a greater early default risk that those without similar help, it may not be the downpayment assistance that’s causing the elevated risk, Stegman noted.

Counterintuitively, higher downpayments may actually increase defaults by decreasing homeowner liquidity. A June 2019 study from the JPMorgan Chase Institute found that higher downpayments may increase defaults because it decreases homeowner access to cash and thus their ability to withstand financial stress. The study found that borrowers with the post-closing equivalent of less than one month’s mortgage payment defaulted at least five times more often than borrowers with three or four months of post-closing cash, regardless of the homeowner’s equity, income level or payment burden. 

“If the strategy based on maintaining a minimum amount of post-closing liquidity in an emergency mortgage reserve account is impactful and cost-effective, it may be a better approach to default prevention than underwriting standards based on meeting a total DTI (debt-to-income) threshold at origination,” the study concluded.

Low downpayments reduce the time it takes to save for a downpayment. Buying earlier makes a big difference in amassing wealth through housing. A 2018 Urban Institute study found that people who bought their first home between the ages of 25 and 34 build nearly $150,000 in median housing equity by age 61. 

That’s much more than those who waited to buy their first home. The people who bought between ages 35 and 44 had $72,000 less in equity by age 61 than those who bought between 25 and 34. For those who wait until they are 45 or older, the median equity is more than $100,000 less by age 61.

“Today’s young adults are failing to build housing wealth, the largest single source of wealth, at the same rate as previous generations. While people make the choice to own or rent that suits them at a given point, maybe more young adults should take into account the long-term consequences of renting when homeownership is an option,” the study suggested.

Reducing defaults 

Mortgage insurance reduces loan default losses, even on those with LTVs lower than 60%. In a study of Freddie Mac data between 1999 and 2004, Urban Institute researchers found that losses on loans with LTVs above 80% were much lower than for loans with LTVs between 60% and 80%. In fact, the seriousness of losses for these high LTV loans are not too different from (and in many cases, less than) that of sub-60% LTV loans.

The reason is simple. Loans with LTVs above 80% are required to have mortgage insurance, which covers the first loss. This coverage is usually deep enough that the mortgage holder is not exposed unless the market value of the home drops much more than 20%.

Prepurchase homeownership education has been shown to reduce delinquency and default rates among lower-income borrowers using downpayment assistance. From 1990 to 2010, families that participated in Massachusetts’ SoftSecond mortgage program (designed to help first-time homebuyers with lower incomes to finance downpayments) experienced lower delinquency rates than the state’s subprime and prime borrowers during the same period. 

Tennessee’s downpayment-assistance program for first-time homebuyers with low and moderate incomes required participants to receive education on prepurchase and post-purchase topics from an agency certified by the U.S. Department of Housing and Urban Development (HUD). These buyers were much less likely to have experienced foreclosure than a comparison group without the education piece, while the amount of money these households saved by avoiding foreclosure far exceeded the cost of the education.

Mortgage originators can educate consumers about the pros and cons of lower-leverage mortgages so that buyers understand they have options they never considered.

Educating consumers

Likely deterred by the coronavirus pandemic, fewer homeowners have listed their properties for sale this year, with annual declines of 19% or more this past April, May and June. The dramatic decline in new listings is exacerbating an inventory drought that has been raising prices and depleting supplies of affordable starter homes for years. Higher prices increase the cost of downpayments and lengthen the time it takes for a first-time buyer to become a homeowner. That is why first-time buyers made a median downpayment of only 6% last year, according to the National Association of Realtors (NAR).

Lower downpayments are the lifeblood of the first-time buyer business, which is now responsible for one-third of all sales. By learning more about how to mitigate risks associated with lower downpayments and downpayment assistance, the mortgage industry can remove the barriers to homeownership for new generations and underserved minorities.

These times cry out for leadership from policy-makers, including Fannie Mae and Freddie Mac, HUD, FHA, mortgage lenders, Realtors and trade groups. Real estate agents and mortgage originators can educate consumers about the pros and cons of lower-leverage loans so that buyers understand they have options they never considered. Trade associations should promote the role that expanded access to downpayment assistance, coupled with homeownership education, can play in closing the racial homeownership gap.

Lenders should review underwriting policies in light of recent research that suggests first-time buyers with higher downpayments are at greater risk of default than those with lower downpayments and more available cash for emergencies. They might discover they are losing business to competitors and are increasing, not decreasing, their risks of delinquency and default. 

Federal policymakers and members of Congress should understand the unique role that downpayment assistance plays in helping first-time buyers and low- to middle-income families achieve the American dream. Whether the goal is increasing minority homeownership or expanding economic growth by creating more homeowners, downpayment assistance works. ●


  • Rob Chrane

    Rob Chrane is CEO of Down Payment Resource, which connects homebuyers with hard-to-find downpayment programs. He has more than 30 years of experience as a top producer and executive in the real estate and mortgage finance industries. In 2015, Chrane was recognized with a HousingWire Vanguard Award for his leadership in the housing economy. Down Payment Resource has been noted as one of the industry’s most innovative technology companies by HousingWire Tech100 and Inman News.

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