Socking away mortgage payments can reduce your likelihood of default when income drops
No one wants a repeat of the foreclosure debacle and the housing crisis. At the same time, lenders and economists continue to evaluate what happened and how to provide funds for home buyers without taking on too much risk.
Although loans that require no or low down payments have often been identified among the reasons that borrowers were unable to keep their homes when prices plummeted, a study by the JPMorgan Chase Institute finds that cash in the bank is more important in preventing default than the size of the down payment.
Obviously, it would be better for home buyers to make a down payment of 20% or more and have several months of cash reserves when they purchase a home. But the reality is that high home prices make it more difficult to save for a substantial down payment. First-time buyers made a median down payment of just 7% in 2018, according to the National Association of Realtors' Profile of Home Buyers and Sellers.
The Chase research found that having cash in the bank to cover three mortgage payments was more important than the amount of home equity, the income level of the homeowners, or the size of the mortgage payment in relation to household income to prevent default. Borrowers in Chase's study with less cash than the equivalent of one mortgage payment in the bank had a three-year default rate (1.8%) that was more than five times higher than borrowers who had cash in the bank to cover three or four months of mortgage payments.
Homeowners who had lacked the cash to cover one mortgage payment accounted for 20% of the people surveyed but made up 54% of those who defaulted on their loans.
An important measure of creditworthiness used by lenders is the debt-to-income ratio, which compares all minimum monthly debt payments with the homeowners' gross monthly income. Typically, lenders want to see a debt-to-income ratio of 43% or less.
But the Chase research found that the ratio when the loan was approved didn't have a significant impact on loan defaults. Among homeowners who were unable to pay their mortgage, the default was preceded by a drop in income. Across all levels of debt-to-income ratios, half of homeowners who defaulted lacked the cash to cover 1.4 months of their mortgage payment.