Down payment assistance programs need greater scrutiny
Down payment assistance programs: will they result in more defaults?
The answer to that question depends on whether or not the assistance weakens the role of down payments in minimizing mortgage defaults and losses from defaults. Such losses are borne by whoever bears the risk of default: the lender, or the investor who purchases the loan from the lender, or the entity that insures the investor against loss.
The down payment is a buffer against loss in the event the borrower defaults. The larger the down payment, the larger can be the foreclosure costs plus decline in house value before the risk-bearer suffers loss. This is the "buffer role" of the down payment.
In addition, the capacity of borrowers to save for a down payment is correlated with their capacity to make monthly mortgage payments. Borrowers who have trouble saving for a down payment also have trouble making mortgage payments on time. The down payment is an indicator of the strength of the borrower's budgetary discipline. This is the "indicator role" of the down payment.
Most assistance programs have been on FHA loans. Since FHA requires only 3.5 percent down, it might seem strange that FHA is the focus of down payment assistance programs. The reason is that there is always a segment of the population that aspires to homeownership but has no capacity to make any down payment at all, and the risk associated with meeting the demand of this group is assumed by FHA. The major issue to the lenders who deal with this group is meeting the requirements of FHA. The major issue to FHA is fashioning rules that will protect its insurance reserve fund against major losses.
FHA allows a contribution to the borrower's down payment, but it must be an outright gift. The logic is that if the contribution is a gift, it will not inflate the house price. Gifts are allowed from a family member or friend, the borrower's employer or union, a charity, a government agency, or a nonprofit corporation or charity.
Allowing bona fide gifts retains the buffer role of down payments, but it doesn't touch the indicator role.
On FHA loans, home sellers can contribute up to 6 percent of price to cover the buyer's settlement costs, but cannot contribute anything to the down payment. FHA seems to believe that by limiting seller contributions to the buyer's settlement costs, the buffer role of the down payment is protected. This ignores the fact that a seller who contributes to a buyer's settlement costs expects to recover the contribution in the sale price. From the seller's perspective, the incentive to raise the price is the same whether the contribution covers settlement costs or down payment.
For example, assume the seller marks up the house price from $100,000 to $106,000 based on a $6,000 contribution to the buyer's settlement costs. If the appraisal comes in at $106,000, the loan amount rises from $96,500 to $102, 290, and the cash required of the borrower drops from $9,500 to $3,710. But if the house is worth only $100,000, the true down payment is negative $2,290. Allowing home sellers to pay settlement costs erodes the buffer role of the down payment.
Beginning in 1998, FHA allowed several nonprofit corporations to develop programs offering down payment assistance using funds provided by home sellers. These programs gradually grew in importance, accounting for almost one-fifth of FHA originations during 2004-2008. They also resulted in disproportionately high loss rates to FHA, and Congress ended the program Oct. 1, 2008, with FHA's approval.
Beginning in 2011, state housing finance agencies (HFAs) began providing down payment assistance, through grants or second mortgages, funded by the sale of Ginnie Mae mortgage-backed securities. The securitized FHA loans carry a premium interest rate, which allows the Ginnie Mae security to be sold at a premium price, which allows the HFA to recover its assistance payment to the borrower.
Unlike seller contributions, HFA assistance does not tend to raise the sale price of the house. Instead, it raises the interest rate, and with it the monthly payment. That in itself could adversely affect default rates, but in all likelihood any such affect would be small. The major concern about these programs is that they provide financing to wannabe homebuyers who can't meet a 3.5 percent down payment requirement, many of whom may not have the budgetary discipline needed to be successful homeowners.
But the proof of the pudding would be in the numbers. FHA should be maintaining separate records on default rates of borrowers receiving HFA assistance, as it did with the organized seller contribution plans referred to earlier. According to a critical report on down payment assistance by the HUD Office of the Inspector General, they are not doing it.
• Contact Jack Guttentag via his website at mtgprofessor.com.