More borrowers qualify of down payment requirements are low, but those buyers are weaker, so the housing market is less stable.

Large down payments are the bedrock of the housing market because large down payments preserve home ownership, reduce volatility in the market, and reduce the risk to our financial system. The only people who oppose them are realtors and originate-to-sell lenders who see down payments as an impediment to profits and left-wing housing advocates who see down payments as a barrier to putting unqualified borrowers into houses.

Down payments preserve home ownership because people who’ve put down large down payments rarely default. In purely economics terms, people shouldn’t consider sunk costs like down payments in their decision making; however, homeowners do. People simply don’t walk away from properties where they’ve put a lot down, even if they’re deeply underwater. The decision is more emotional than logical, but coupled with the emotional desire to “own” these two forces prevent most people from strategic default even when that option is the best available to them.

Large down payments provide stability to the housing market. But how large is large?

There is no way to accurately measure how much skin in the game motivates people to stay and pay. Everyone knows it’s important, but with no way to accurately gauge how much is required, the forces demanding little or no down payment are winning — and for good reason — New down payment requirements could crash housing again.  Unfortunately, completely eliminating down payment requirements leaves us with borrowers putting no skin in the game, and quite frankly, that’s a horrible idea.

A high down payment requirement greatly reduces the potential buyer pool whereas a low down payment requirement greatly increases it. This basic fact is why lenders and their lobbyists are working so hard to get down payment requirements lowered or eliminated. Any down payment requirement is an impediment to doing more business. In fact, if down payment requirements were reduced to zero, that barrier to home ownership would be effectively removed. Lenders tried that during the housing bubble, and it was a disaster. Lots of people who didn’t have any savings — or any sense of financial responsibility — took lenders up on their generous offers for free houses. This was a major contributor to the housing bubble and bust, and the resulting losses cost lenders — and taxpayers — billions.

For lenders and investors in mortgage-backed securities, large down payments provide a buffer that minimizes their losses if borrowers do default. Any down payment of 10% or more allows the borrower to sell, pay closing costs and commissions, and fully repay the loan. Down payments of 20% or more gives the lender a buffer of 10% in cases prices decline while the borrower owns it. Price drops of 10% or less are possible in a weak economy even if lenders don’t inflate a bubble. Large down payment requirements serves borrowers, lenders, and ultimately taxpayers who end up subsidizing and backstopping both parties. It doesn’t serve the short-term desires of originate-to-sell lenders, and implementing high down payment requirements will impact the efforts of lenders to reflate the last bubble, but for the greater good, down payment requirements must be at least 10% with 20% being preferred.

Down payment requirements

Down payment requirements have traditionally been very high. During the 1920s, interest-only loans with 50% down payments were the norm. Very few people owned their houses. By the 1950s, conventionally amortized loans with a 30-year term and 20% down payments became the norm, and house prices rose significantly from the bottom of the Great Depression to the 1950s due to the increased use of leverage in real estate.

That is the end of the road for financial innovation. All attempts to tinker with the stability of conventional financing have failed because they are all Ponzi Schemes. People must have a reasonable expectation of paying off a loan in their lifetime. Multi-generational debt is frowned upon here in the United States, so any term beyond 30 years really doesn’t make sense. If borrowers feel like they will never pay it off, they will not try, and they fall into Ponzi thinking and borrow in terms of maximum debt service, a collective insanity.

By 2005, Option ARMs and 100% financing left us with 0% down payments as the cycle reached its ultimate limitation — they were giving it away. Not surprisingly, prices skyrocketed; unfortunately, the terms of the Option ARM were not stable and the Ponzi Scheme blew up. Today, we are back to the 1950s in the world of mortgage finance — and that is a good thing.

The 30-year fixed-rate fully-amortizing loan is the only stable loan product, and a significant down payment is required to keep down speculation. As down payments get smaller, the incentives to speculate with lender money get larger. With no-money-down the incentive to speculate hits infinity. One-hundred percent financing with no qualification is a free-for-all no-limit housing market casino.

Savers gain advantage bidding on real estate

Most buyers don’t have 20% to put down on a home, particularly first-time homebuyers. Most buyers don’t have the current FHA standard 3.5% down either, or we wouldn’t have tried 0% down to begin with. When it is an FHA buyer, they generally only put the minimum 3.5% down. The loan plus the down payment is about 16.5% lower for an FHA buyer than it is for a conventional borrower putting 20% down, assuming both are qualified using the same income and same DTI. Further, the FHA buyer pays a significant insurance premium which cuts into their ability to finance a large mortgage. The same debt-to-income ratio thereby supports a smaller loan balance.

In the real world, the conventional borrower is also utilizing a higher DTI ratio. Instead of being limited to the FHA 31% front end DTI, conventional borrowers are often allowed to go into dangerous waters with 32% to 38% DTI levels. This additional money put toward debt service makes for larger loans. The borrower with enough cash to put 20% down has a significant bidding advantage over the FHA buyer, which is why most home sales in OC are to conventional buyers.

The lower down payment amount and the smaller loan balance make FHA less desirable than conventional financing for borrowers looking to bid up prices. FHA financing can be looked at as training wheels for mortgage borrowers, as most first-time homebuyers use it.

After some period of time in a normally appreciating market (if there is such a thing), the combination of loan amortization and home price appreciation results in home equity exceeding 20% of the resale value of the property. When there is enough home equity that a more expensive house than the borrower’s current home equity, they cross a threshold; they have access to the higher DTIs, and they can borrow more money to take the next step up the property ladder — if they are willing to give up some disposable income to have the house.

In the end, it is not the highly leveraged that gain the upper hand in real estate, it is the savers. The real estate market will always boil down to loan plus down payment. The more money people have saved, the greater their down payment and the more they can bid to compete with others at their income level. The saver always comes out ahead.

How to save for a down payment

The biggest barrier to sales today is the lack of a down payment. In the post How restricted for-sale housing inventory saps demand, I demonstrated how stagnant wages and high rents prevent people from saving enough to obtain a down payment on a house. It’s one of a number of reasons Millennials aren’t buying homes at a stage in their lifecycle when previous generations did.

During the housing bubble, people had access to 100% financing, so few were saving for a down payment. After the housing bubble, the Great Recession caused many people to dip into savings just to make ends meet. Further, since the federal reserve lowered interest rates to zero, beyond the emotional need for reserves for stress reduction, people had little or no incentive to save.

The end result of these circumstances is that very few potential homebuyers have the necessary down payment, even the paltry 3.5% required by the FHA. And since renters put a large percentage of their income toward rent, even if they wanted to endure 0.2% savings interest rates, they don’t have the disposable income necessary to save for a down payment. There is no magic bullet or simple solution to this problem.

Perhaps it’s “old school” and unfashionable in our modern era of unlimited entitlement, but the only way to save for a down payment is for potential homebuyers to sacrifice current consumption and adjust their finances to live within the constraints of their income.

Adjusting finances

People can adjust to whatever income and expenses they have if given a little time. Transitioning from renting to home ownership shouldn’t be a difficult adjustment if you follow a few simple guidelines for structuring your finances while you’re still renting. To make the adjustment, you need to carefully budget for saving for a down payment and making the house payment once you purchase. Fortunately, this is not as difficult as some imagine.

PITI

The first task is to figure out how much you will have to spend each month when you own your home. Lenders don’t pity borrowers, but they are very concerned with an acronym called PITI, a formula they use to calculate the maximum monthly payment you can afford. PITI is short for principal, interest, taxes and insurance, but it also includes other known costs such as HOA dues and mortgage insurance. When a lender calculates the maximum loan they will extend a borrower to buy a particular property, they start with the borrowers income and apply the maximum debt-to-income ratio, currently 31%. They take this number and divide it by 12 to come up with a maximum PITI.

For example, let’s say a borrower making $100,000 per year wants to buy a home. The lender will allow them to put $31,000 per year ($100,000 x 0.31) or $2,583 per month to cover PITI. This number is very important because it tells you how much you can expect to write checks for each month if you max out your loan (most do) to buy a home.

Rent and Savings

As a renter hoping to buy, you must adjust your lifestyle to fit within your PITI amount. Your current rent should be far enough below this figure to allow you to save money for your down payment. But how much below? What is a good guideline for determining the maximum rent you should be paying each month? This is an important question because if you base your selection of a rental based on the PITI of your ultimate cost of ownership, you will also become accustomed to living in the quality of home you will ultimately afford to purchase. Fortunately, there is a formula to figure this out.

I’ve run the cost of ownership calculations on thousands of properties. The monthly cost of ownership is generally 25% to 30% below PITI. This monthly cost of ownership relates to rental parity, the foundation of housing market values.

If you use that guideline, a renter making $100,000 a year should be paying about $1,900 in rent and saving about $700 per month toward a down payment. That translates to a 23% rent-to-income ratio. Anyone with the discipline to live this way will be able to save for a down payment and comfortably transition to home ownership. Anyone who doesn’t have the discipline to live this way may not be cut out for home ownership.

From the above example, a $440,000 conventional loan balance leaves a $110,000 down payment to purchase a $550,000 house. Notice that 3.6% interest rates allow borrowers to purchase at price-to-income ratios of 5.5. That’s very high by historic standards.

It only takes 20 months to save for a down payment

At $700 per month, it will take 158 months to save the $142,052 for a down payment. Thirteen years is a very long time. That’s why so many people opt for FHA financing with 3.5% down. At $700 per month, it only takes 20 months, or just over a year and a half, to save the $13,825 required to cover the FHA down payment on a $395,000 property.

Did you notice the catch to using FHA financing? People who don’t have a 20% down payment have to settle for much less house on the same income. This is why the tradition of buying a starter home, waiting until it accrues 20% equity, then selling for a move-up is such a big part of our housing market.

The bottom line

To prepare for home ownership, rent a property using 23% or less of your gross income. Save 8% of your gross income in a special down payment account you don’t raid for other lifestyle expenses or purchases. In less than two years, you will have the down payment to purchase a property comparable to your rental using FHA financing.

With the discipline you gained from living within your means and saving for a down payment, you will succeed as a home owner and build equity through paying down a mortgage. You might even be rewarded by the appreciation fairies and complete a move-up once you have about 30% equity in your home and you can sell, cover the closing costs and still have 20% for a down payment on a nicer property.

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