September 14, 2015

Most consumers need to borrow some of the money needed to purchase a home, but lenders will seldom provide it all; usually, they require that borrowers provide some of the money out of their own resources. This is called the “down payment requirement.” The questions about down payments shown below have all been posed to me by prospective house purchasers.

Q: What is the down payment?

A: House purchasers are likely to think of the down payment as the difference between the sale price of the house and the loan amount, but lenders and regulators won't accept that definition if the sale price exceeds the appraised value. To them, the down payment is the lower of sale price and appraised value less the loan amount. The down payment is not the same as the borrower's cash outlay if some of that outlay is used for settlement costs, which is usually the case. For example, if the sale price is $200,000, appraised value $203,000, loan amount $175,000 and settlement costs $5,000, the down payment is $200,000 less $175,000 or $25,000. The borrower’s cash requirement is $25,000 for the down payment plus $5,000 for settlement costs, or $30,000. The higher appraisal value does not enter the calculation.

Q: Why do lenders require a down payment?

A: Reason 1 is that borrowers who have documented their capacity to save the funds needed for the down payment are more likely to have the discipline needed to make the mortgage payments. Down payment capacity is an indicator of financial discipline. This assumes the down payment  was saved rather than a family gift.

Reason 2 is that in the event that the borrower defaults, the down payment reduces the amount that the lender must raise through the sale of the property. The larger the down payment, the greater the assurance that the sales proceeds will be sufficient to cover the unpaid loan balance.

Q: What is the connection between the down payment and the LTV?

A: LTV is the ratio of the mortgage loan amount to the property value, and it is equal to 1 minus the ratio of down payment to property value. For example, if the property value is $100,000 and the down payment $25,000, the down payment ratio is 25% and the LTV is 75%. While a minimum down payment ratio of 25% means the same thing as a maximum LTV of 75%, legal and regulatory requirements are usually specified in terms of a maximum LTV because it is less vulnerable to misunderstandings of the types illustrated by the next 4 questions.

Q: If the appraised value of a home exceeds the sale price, can the difference be applied to the down payment?

A: No, as already indicated, the property value upon which down payment requirements are based is the lower of sale price and appraised value. 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 use the appraised value, probably based on two appraisals, rather than the lower sale price. Since the difference is a gift, the seller must follow IRS rules to avoid gift taxes, but this is a minor nuisance.

Q: Can a home seller contribute to the buyer’s down payment?

A: No, 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.

Q: Can the lender contribute to the buyer’s down payment in exchange for a higher interest rate?

  A: No, lenders cannot contribute to the borrower’s down payment. 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.

Q: Can cash gifts be used as a down payment?

A: Only if the gift comes from a relative or live-in partner who can document its source. Gifts from parties to the transaction such as home sellers or builders are not acceptable as down payment funds because of the presumption that the gift affects other parts of the transaction, especially the sale price. The lender must also be convinced that the gift is not a disguised loan with a repayment obligation that might reduce the borrower’s ability to repay the mortgage.

Borrowers who receive undocumented cash gifts can include them as part of their own funds if they can show that the funds have been in their account for at least 60 days. They should have two monthly statements issued after the funds are deposited in the account.

Q: Are there any substitutes for a down payment?

A: In principle, any collateral acceptable to the lender could serve as a substitute for a down payment. The only such substitute found in the US is securities, which must be posted as collateral with an investment bank that also makes mortgage loans. Borrowers who do this are betting that the return on the securities will exceed the mortgage rate.

Mortgage insurance and second mortgages can also be viewed as substitutes for a down payment. They do not provide the first mortgage lender with additional collateral, but they shift a major part of the risk of the low-down payment loan to a third party who is paid by the borrower for assuming it. The payment is either a mortgage insurance premium or a relatively high interest rate on a second mortgage.

Q: Is it wise to withdraw funds from a 401K to make a down payment?

A: Withdrawing funds is very unwise, since you would be hit with taxes and penalties, but borrowing against your account might make sense, provided your employer allows it and you have no plans to quit. The cost of borrowing against your 401K is not the loan rate, which you pay to yourself, but the return the money would have earned if left in the account.

The risk is that if you lose your job, or change employers, you must pay back the loan in full within a short period, often 60 days. Otherwise, the loan is treated as a withdrawal and subjected to taxes and penalties. Loans from a 401K cannot be rolled over into a 401K account at a new employer.

Q: Who sets down payment requirements?

A: Since the purpose of down payment requirements is to reduce the potential loss from borrower default, the requirements are stipulated by the entity that assumes the risk of loss. Prior to 1934, the risk was borne by private lenders, who seldom accepted down payments of less than 40%. With the creation of the FHA program in 1934, the requirement fell to 20%, which was historically unprecedented. Private lenders make the loans but FHA assumes the risk of loss, and borrowers are obliged to pay an insurance premium to cover the losses. FHA is still in the business but today it requires only 3% down.

A similar program for veterans of the armed forces, developed after World War 2 and administered by the Veterans Administration, eliminated down payment requirements for veterans altogether. This program is still in force.

On loans purchased by Fannie Mae and Freddie Mac, the down payment requirements are set by those agencies, which also require that the borrower purchase mortgage insurance from a private carrier if the down payment is less than 20%. Recently, the agencies reduced their lowest requirement from 5% to 3%, but not all borrowers are eligible.

Q: Who is and who is not eligible for a 3% down payment requirement on loans purchased by the two Federal agencies?

A: You are eligible for 3% down if you are purchasing a single-family home as your principal residence using a fixed-rate mortgage. Switch to an adjustable-rate and the requirement jumps to 10%. If the house will be your second home, the requirement jumps to 20%. If you are buying the house as an investment, it goes to 25%. And if the property has 2-4 units instead of 1, the requirement is 35%. Many other permutations and combinations can be found on the Fannie Mae web site.

Q: There is never any reason to make a larger down payment than the one required, right?  

A: Wrong, making a larger down payment is an investment that yields a rate of return that in some circumstances can be very attractive. The rate of return on the funds used to make a larger down payment is at least as high as the mortgage interest rate, and usually higher. The mortgage interest rate determines the interest savings on the amount you don’t borrow. If you increase your down payment by $10,000 on a 4% mortgage, for example, you earn 4% on the $10,000 you didn’t borrow. The rate of return is increased by any points or mortgage insurance required on your loan, since you also avoid these payments on the money you don’t borrow. My calculator 12a shows the total rate of return on investment in a larger down payment taking account of all cost reductions.