Large down payments stabilize the housing market

Large down payments shut many borrowers out of the housing market — many unreliable ones — which is why large down payments make housing so stable. It’s also why many rally against it.

Down payments form the bedrock of the housing market. Large down payments serve the interests of homeowners and politicians by

  1. preserving homeownership,
  2. lowering volatility in the market, and
  3. reducing the risk to our financial system.

The primary people who oppose large down payments profit from short-term boosts in transaction volumes and higher prices, realtors and originate-to-sell lenders. Left-wing housing advocates also view large down payments as a barrier to putting unqualified borrowers into houses — of course, they fail to acknowledge the “unqualified” nature of many of these borrowers.

Down payments preserve home ownership because people who invest 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 invested a great deal of their own money, even if they’re deeply underwater and that money is only a memory. The decision is more emotional than logical. But when coupled with the emotional desire to “own,” these two forces dissuade most people from strategic default even when that option is the best available to them.

Down payments clearly have a strong impact on delinquency that can’t be ignored. Delinquency rates on high down payment loans are a small fraction of what delinquency rates are on low down payment loans.

Down payment reduce market volatility in two ways. First, as mentioned previously, large down payments reduce strategic default. Fewer foreclosures in a time of financial crisis means less pressure on house prices. Plus, large down payments serve to limit the inflation of prices during a rally. Large down payments reduces the size of the buyer pool (which is why lenders and realtors want down payments reduced or eliminated). A thinner buyer pool puts less upward pressure on prices. It takes people time to save for larger down payments, and this serves to limit price increases by the rate of savings of potential buyers.

Ultimately, down payments limit the risk to our financial system because they reduce the volatility in the housing market. Our financial system nearly crashed in 2008, which was triggered by the collapse of the housing bubble.The destabilizing impact of low down payments is far reaching. That’s why it’s particularly dangerous that a small group of self-interested parties is lobbying to reduce or eliminate down payment requirements from the new qualified residential mortgage standards.

The downside of large down payments

Over the last 10 years, and even now, politicians and bankers obsess over increasing lending to stimulate the economy. Large down payments limit lending because it prevents people without the fiscal discipline to save and consistently make payments from obtaining loans.

However, this type of myopic thinking ignores the basic reason down payments are so important: Down payment requirements weed out the people lenders should least want to loan money to. (See chart above).

And who said home ownership is an entitlement that lower-income borrowers should have? Lower income borrowers who can save 3.5% can buy a property that their income can support. The FHA down payment hurdle is hardly onerous.

Dodd-Frank whiffed on down payments

While the new mortgage regulations will prevent future housing bubbles, these regulations leave out the lynchpin of the whole system, down payments. For decades, experts emphasized the need for a sizable down payment — a rule of thumb being 20 percent — on the premise that borrowers with a sizable chunk of equity in a home are less likely to walk away when things get bad.

If our goal is to prevent foreclosures, I can’t think of anything more effective than requiring a down payment,” said Paul S. Willen, a senior economist and policy adviser at the Federal Reserve Bank of Boston.

As I noted, large down payments prevent many from submerging beneath their debts, leading to a reduction in strategic default. Fewer defaults mean fewer foreclosures. However, it isn’t just the number of foreclosures that’s the problem. The losses lenders must absorb if they do foreclose is what imperils our banking and financial system.

If the bubble-era borrowers all put 20% down in their respective banks (swift code transfers), banks wouldn’t have lost so much money during the bust. In fact, if you pay careful attention to what the Chinese say about their own housing bubble, they insist it isn’t a problem precisely because their down payment requirements are so high.

There is no reasonable argument to be made in favor of small down payments. The only people trying to obfuscate the issue are left-wing housing advocates, realtors, and originate-to-sell lenders who have their own self-serving agendas. The reality is that large down payments provide stability to housing markets and our financial system.