Perspectives on Down Payment Requirements

The down payment required on a home mortgage is the single most important hurdle that prospective home purchasers must surmount. This article explains what a down payment is exactly, looks at some possible sources of down payment funds, explains why the down payment is critical to lenders, and describes the requirements today.

The down payment on a home mortgage is the lower of the sale price and appraised value, less the loan amount. It is not the same as the borrower's cash outlay if some of that outlay is for settlement costs, which is usually the case. Land can be part or all of the down payment.

A minimum down payment, expressed as a ratio to the lower of sale price and appraised value, means exactly the same thing as a maximum loan-to-value, or LTV. For example, if the property value is $100,000 and the down payment $25,000, the down payment ratio is 25 percent and the LTV is 75 percent. Legal and regulatory requirements are usually specified in terms of a maximum LTV rather than a minimum down payment because the LTV is less vulnerable to misunderstandings.

Last week I looked at borrowing from one's 401(k) account as a source of down payment funds. Here are some other possible sources:

Excess of appraised value over sale price: In general, this is not allowed. As noted above, the down payment is defined as the lower of sale price and appraised value less the loan amount. Hence, an appraisal higher than the price is disregarded.

But there is an important exception, called a gift of equity, where the home seller - usually a family member - is willing to sell below market value. In such cases, the lender will calculate the down payment using the appraised value, probably based on two appraisals, rather than the lower sale price. If the transaction has some risky features (as in the table below), the lender may not accept the equity gift as the full down payment and will expect the borrower to make a contribution - perhaps 5 percent.

Home seller contributions: These are not allowed, because of a presumption that such contributions will be associated with a higher sales price. However, subject to limits, home sellers are allowed to pay purchasers' settlement costs. This reduces the cash drain on purchasers, allowing more of it to be used as down payment.

Lender contributions granted in exchange for a higher interest rate: These are not allowed either. However, cash-short borrowers can select a relatively high-rate loan that carries a rebate, or "negative points," and the rebate can be used to pay settlement costs. This reduces the borrower's required cash without affecting the down payment.

Cash gifts from home sellers, builders or other parties to the transaction: These are not allowed because of the presumption that the gift affects other parts of the transaction, especially the sale price.

Cash gifts from a relative or live-in partner who can document the source: These are acceptable as down payment funds. However, the lender must be convinced the gift is not a disguised loan with a repayment obligation that might reduce the borrower's ability to repay the mortgage.

Why is the down payment so important to lenders?

One reason is that the down payment is a buffer against lender loss in the event of a foreclosure. For example, if foreclosure costs are 20 percent of value, and property value does not change, a 20 percent down payment fully protects a foreclosing lender against loss, but a 10 percent down payment provides only partial protection.

Perhaps even more important, borrowers who get into payment difficulties but have equity in their properties usually will sell to avoid foreclosure. By selling, they realize the equity themselves whereas, if they allow the property to go to foreclosure, the equity will be partially or wholly depleted by foreclosure costs. Their incentive to sell and avoid loss of the equity, or their down payment funds, often avoids foreclosure.

In addition, borrowers who have been able to save the funds for a down payment are less likely to get into payment troubles later on. Saving for a down payment requires budgetary discipline; repaying a mortgage also requires budgetary discipline. One carries over to the other. Of course, this assumes the down payment is saved, not borrowed.

In the 1920s, before the federal government became a player in the market, commercial banks and insurance companies generally required 50 percent down, while savings and loan associations, which were the mortgage specialists, were more liberal - they required only 40 percent down. Today, requirements range down to zero on VA-guaranteed loans, and to 3 percent on loans insured by FHA or approved for purchase by Fannie Mae or Freddie Mac.

However, the low down payments required by Fannie Mae and Freddie Mac apply only to what the agencies view as the lowest risk transaction, which is the purchase of a single-family home intended as the purchaser's principal residence, with a fixed-rate mortgage. Other types of transactions are subject to higher requirements, as shown in the table.

On loans that are too large to be insured or purchased by a federal government agency but are otherwise viewed as low risk, the minimum down payment is 20 percent. This also scales up on transactions viewed as being more risky.

• Contact Jack Guttentag via his website at mtgprofessor.com.

© 2017

Fannie Mae down payment requirements by transaction type

<b>Transaction type Down payment required</b>Purchase of single-family principal residence, with fixed-rate mortgage 3 percent

Purchase of two-family principal residence, with fixed-rate mortgage 15 percent

Purchase of two-family principal residence, with adjustable-rate mortgage 25 percent

Cash-out refinance on two-family principal residence, with adjustable-rate mortgage 35 percent

Cash-out refinance on two-family investment property, with adjustable-rate mortgage 40 percent