The Down Payment

Almost nobody pays cash for a house.  Instead, you pay for most or all of it by getting a loan from a bank, called a mortgage. You will also most likely make a down payment of 3.5 to 20% of the sale price.  Since everybody wants to know how to get a house with zero down, we'll cover that first.

No-money-down loans

It used to be easy to get a zero-percent down mortgage, but not any more.  These days zero-down loans are generally available only to veterans with good credit.

No-money-down loans surged in popularity in the 2000's, going from 4.5% of loans in California to 20% from 2000 to 2007. (SacBee)  Among first-time homebuyers the figure was even higher, with a whopping 43% of them paying nothing down in 2006, up from 28% just two years prior to that. (Washington Post)  But banks got burned on these loans because people who couldn't scrounge up a down payment were more likely to default on their loans (duh), which is part of what caused the mortgage lending crisis. (See sidebar.)  So today banks generally don't make zero-down loans, just like they didn't before the lending crisis. The main exception is for veterans with good credit scores, who can still sometimes get zero-down mortgages.

The Subprime Lending Crisis

Here's what happened in a nutshell: Subprime basically means "bad credit", so a subprime loan is a loan made to someone with bad credit. Lenders gave these out like candy from about 2000-2006. And of course, people with bad credit are more likely to fail to make their payments and have their houses repossessed by the bank ("foreclosed"). When a bank forecloses on a house it then sells the house to get back the money they loaned out for it to be bought in the first place.  But wait!  The real estate market took a dip in 2006, so those repossessed houses were suddenly worth a lot less.  So a bank might have loaned out $200,000 on a house, but was only able to sell it for $180,000.  Uh-oh.  Multiply this by thousands of homes, and you can see that lenders lost a lot of money.  Ta-Da!  That's the Subprime Lending Crisis.  Lots of these subprime lenders went bankrupt.  One of the casualties was New Century Mortgage, a huge lender with nearly $2 billion in markket capitalization, and which had actually handled the loan on one of my homes.  (Not that I got a subprime loan -- my credit is excellent. New Century handled regular loans too.)

As a result of this subprime mess, it's now a lot harder for borrowers to get loans. Lenders are being a lot more careful about whom they lend to.

You might wonder why PMI didn't protect lenders.  After all, that's what it's supposed to do:  Pay banks when borrowers default.  One reason is that many banks made 80/20 loans (explained elsewhere on this page) which didn't require PMI.  So there was no PMI to help.  Another reason was that banks were required to foreclose first before they could collect the insurance benefit, but they didn't have the resources to handle an unprecedented number of foreclosures.  Finally, part of the crisis was actually the PMI insurance companies themselves getting hit hard.  In 2011 the PMI Group filed for Chapter 11 bankruptcy. (HuffPost) 

But this begs the question: Even if you can get a zero-down loan, is it a good idea?  Not necessarily. Here are reasons to think twice about getting a 0% down loan:

  • More likely to lose your home. If you can't make a down payment it's either because you didn't have the financial discipline to save, or you're not making enough money. Either of those things makes it more likely that you won't be able to make the payments on your house, and that you'll get foreclosed on and lose your house. A study in Denver showed that over half of foreclosures involved nothing-down loans. (Denver Post)  Ouch.
  • Higher monthly payments. The less money you put down, the more you're borrowing. And the more you're borrowing, the higher your monthly payments.
  • Nothing down means a smaller home. The less you put down, the less the bank is willing to loan you. That means your options will be more limited as far as what homes you can buy. With a down payment -- any down payment -- you can get a bigger loan, and are more likely to be able to get the home you really want.
  • Harder to find the loan. No-money-down loans are harder to find than something-down loans, which are ubiquitous.
  • Harder to qualify. It's harder to get a bank to give you a no-money-down loan than a loan where you put anything down.
  • Private Mortgage Insurance. If you put nothing down on a conventional loan, you'll have to pay for private mortgage insurance. Actually, you'll pay this for any down payment less than 20%, but the less you put down, the more the PMI, and the longer you have to pay it.

So even if you can get a zero-down loan, I encourage you to put down at least 5% if you can.  And if you can't, think long and hard before you accept a zero-down loan.


Don't plan on borrowing the down payment from relatives

The down payment has to be your money.  Why?  Because when the bank gives you the main loan on your house, they've calculated that you won't be able to pay back your loan if you take on additional debt, and borrowing the down payment is additional debt.

But what if someone gives you the money for a down payment (your parents, maybe)?  That's okay as long as you get an FHA loan, but not if you get a conventional loan. (Realize though that many sellers won't agree to an FHA loan because it sometimes adds a little red tape and because the inspectors are more strict about the condition the house has to be in before it can be sold.)


Should you use your free cash to make a bigger down payment or to pay down debt?

A very common question among homebuyers is, "Should I use my extra cash to pay down my credit card debt, or should I save it all for the down payment?" That requires a detailed answer, so just for you, I've written a detailed answer.


How big a down payment should you make?

If you can afford to put 20% down, you should. You'll get a better interest rate, won't have to pay for private mortgage insurance, will qualify for a larger loan, and will save a bundle on interest.

In fact, if you can afford it, there's nothing wrong with putting down more than 20%, as long as you still have enough free cash on hand for emergencies. Remember, once you put money into your house, it's not easy to get it back out, so keep that in mind before you deplete your emergency savings.

80/20 Loans

You might have heard of 80/20 loans as a way to get 100% financing, but they're generally not available any more.  If that explanation is good enough for you, feel free to skip to the next lesson.  Otherwise, here are the details.

Before the lending crisis, banks would often give buyers 100% financing through a loophole:  Instead of doing one 100% loan, they'd make two loans, one for 80% and the other for 20%.  Why wouldn't they just do a single 100% loan?  Beats me.  The 20% loan usually carried a higher interest rate, and that probably had something to do with it.  Anyway, the advantages for the buyer were that they could get 100% financing, and they would avoid having to pay for PMI.

But people who buy with 100% financing are more likely to default on their loans, and it's harder for banks to recover their investment since those houses have little to no equity.  As a result, 80/20 loans are generally no longer available.
Last update:  November 2012.  

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