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Mind the Down Payment

By Rob Chrisman, Senior Advisor

Yes, we’ve seen a big move higher in mortgage rates. But loan officers will tell you that the smart move is for buyers to purchase a home when they find one they’ll love to live in, with a down payment and monthly payment they can afford. Over the long term, it is generally better for buyers to jump into real estate as soon as they can rather than waiting to time interest rates. The Urban Institute released its updated report, “Mortgage Insurance Data At A Glance – 2023,” which showed that government-sponsored enterprise (GSE) mortgages, namely Freddie Mac and Fannie Mae, with private mortgage insurance (MI) have been the most common execution for low down payment borrowers since 2018. Originators should take note, and make sure that borrowers care.

For first-time home buyers, the down payment, and the monthly mortgage amount (in essence, the interest rate they’re approved for) are on top of the list in considering buying a home. When these variables change, most recently as rates have increased as we’ve moved through 2023, it affects the price a household is willing and able to pay for a home. In turn, this affects the housing market overall; economists would call this market sensitivity, and measuring this change in demand is notoriously difficult.

Some years ago, the Federal Reserve of St. Louis addressed this topic and found that a change in down payment requirements tend to have a large effect on housing demand, namely households’ willingness to pay for a given home, especially for current renters. The Fed found that on average the willingness to pay, or WTP, increases by about 15 percent when households can make a down payment as low as 5 percent of the purchase price instead of having to put down 20 percent. Originators often must educate borrowers that there are many loan programs that don’t require 20 percent down.

But the study notes that this average masks large differences in sensitivity across households. In fact, almost half the respondents do not change their WTP at all when the required down payment is lowered. On the other hand, many respondents increase their WTP very strongly in the second scenario with the lower down payment requirement. This is particularly true for respondents who are current renters; their WTP on average increases by more than 40 percent. They also tend to choose lower down payment fractions than current owners. For instance, 59 percent of renters but only 36 percent of owners choose a down payment fraction of 10 percent or lower.

The reaction to down payment requirements differs beyond current owners and renters. Just looking at owners, the reaction is stronger for those with lower current wealth, lower income, and lower credit scores. This finding is important for LOs since it suggests that liquidity constraints play a substantial role in individuals’ willingness and ability to pay for a home. Furthermore, it implies that any change in required down payments will have differential effects across borrower types and segments of the housing market.

While these findings may not be completely shocking across the mortgage banking industry, the survey findings suggest that the strength of housing demand is strongly affected by fundamentals (that is, household wealth and income) and also the quantity of available financing (first-time home buyers in particular). However, the price of available financing (changes to mortgage interest rates) may play a less important role than commonly thought.

Down-payment assistance (DPA) has become an important component of mortgage finance for a growing segment of first-time homebuyers. Because of its explosive growth and the likelihood that it will become a fixture in mortgage finance going forward, policy makers and financial regulators are rushing to define the rules of DPA lending with little analytical evidence to guide them.

Descriptive data from the Department of Housing and Urban Development indicate that serious delinquency rates are generally higher for FHA purchase loans with DPA than for loans without DPA. And within the DPA pool, serious delinquency rates are disproportionately higher for mortgages where DPA came from governmental entities rather than from gifts from family or friends (HUD 2018). In the absence of controls for borrowers and loan characteristics, recipients of grant assistance from a governmental entity appear more likely to default than borrowers who did not receive any assistance.

Would you like some good news? The St. Louis Fed’s study indicated that the receipt of DPA is not significantly associated with default risk. While grant assistance from a government or community organization is marginally significant as a predictor of default risk in one of the Fed’s model specifications, this effect disappears altogether when racial controls are incorporated in the model.

This finding is important because of the importance of DPA to minority borrowers, especially assistance in the form of grants and loans from government programs, rather than from friends and family. Some households with DPA were as able to benefit financially from rising markets as those without DPA, in setting guidelines around down payment assistance, policy makers should take care not to close off opportunities to aspiring minority home buyers.

In this time where every borrower is precious, it behooves every originator to fully familiarize themselves with the down payment assistance programs their company or investor offers. It is yet another way for an LO or broker to demonstrate that “the personal touch” is as important as ever in helping borrowers.

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