You Don’t Need a 20-Percent Down Payment to Buy a House

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One of my New Year’s resolutions is to clear up some of the myths and misconceptions about mortgage loans. The is the first in a series of articles designed to do just that. Today, I’ll be addressing the myth of the 20-percent down payment when buying a house. Here’s a snapshot of what this article contains:

Down Payments on Mortgage Loans

Recent proposals in the financial industry have led many people to believe that a 20-percent down payment is mandatory. But this is simply not true. Let’s separate the myth from the facts.

  • Myth: You need to put at least 20 percent down when buying a house in 2012.
  • Fact: Your down payment might range from 0 to 20 percent, depending on the type of loan you use.

In the current mortgage market, it’s actually rare for lenders to require a down payment of 20 percent. There’s a good reason for this. If they imposed such a requirement across the board, they would seriously limit the number of loans they could make.

QRM Discussions Have Led to Confusion

In an attempt to curb the kind of reckless lending that devastated the housing market a few years ago, federal regulators have made a series of proposals. One of those proposals would require a 20-percent down payment on all Qualified Residential Mortgages, or QRMs.

In this context, a “qualified” mortgage loan is one the bank can sell into the secondary mortgage market. This is the preferred type of loan for most lenders. It minimizes their long-term risks. Under the proposed changes, lenders would have to require a 20-percent down payment on all QRM loans (which would affect most of the loans they make).

But “proposal” is the key word here. None of this has actually been passed into law. It’s a theoretical discussion at this point. In fact, there has been quite a backlash about the proposed 20-percent rule. Banks and consumer groups rightly complain that it would put homeownership out of reach for many Americans.

“The definition of a qualified residential mortgage (QRM) is likely to make borrowing both more difficult and more expensive for consumers,” said Cameron Findlay, chief economist with LendingTree. He added that such a requirement would impose a barrier to many would-be home buyers.

If I were a betting man, I would say the bankers and regulators will eventually agree on a 10-percent down payment requirement for Qualified Residential Mortgages. At any rate, it won’t happen in 2012. If and when a decision is reached, it will be months before implementation.

The bottom line: There is currently no mandatory requirement for a 20-percent down payment on mortgage loans. There is discussion of such a requirement, but nothing more.

Options for Zero-Down Mortgages

Certain types of borrowers can qualify for a mortgage with no down payment whatsoever. The VA loan is one such program. Qualifying service members can get 100% financing through this program. As a Navy veteran, I used this program to buy the house I’m in right now. The VA is not the only way to sidestep the down payment. Low-income borrowers in designated rural areas can get 100% financing through the USDA loan program.

3.5 Percent on FHA Home Loans

Qualified borrowers can get an FHA loan with as little as 3.5 percent down. This is one of the biggest appeals of the FHA program. Home buyers can use it to minimize their out-of-pocket expense. This program is managed by the Department of Housing and Urban Development (HUD). At present, HUD has no solid plans to change the down-payment requirement in 2012. So the program will continue to offer a side door for cash-strapped home buyers who can’t afford 20 percent down.

5 Percent and Up for a Conventional Mortgage

A conventional mortgage is one that is not insured by the government. This makes it different from the VA and FHA loans mentioned above. Generally speaking, these loans must conform to standards established by Fannie Mae and Freddie Mac. These standards currently allow for down payments as low as 5 percent, as long as there is sufficient mortgage insurance on the loan (see “PMI Factor” below).

Granted, some lenders may require larger down payments for borrowers with shaky credit or other risk factors. But the general rule for conventional loans is 5 percent and up.

There was talk of raising the minimum down payment for conforming loans to 20 percent. But the mere discussion of such a change prompted a wave of protest from bankers, consumer groups, and many members of Congress. Representative Emanuel Cleaver II (D-Mo.) said that “a 20 percent — or even a 10 percent — minimum down-payment requirement could relegate [creditworthy individuals] to long term rental status.”

President Obama and his financial regulators have backed off the 20-percent proposal, and are now pressing for a 10-percent minimum down payment. But even that is drawing fire. As of right now, 5 percent is still the minimum requirement for loans purchased by Fannie Mae and Freddie Mac. I expect this to continue throughout 2012. Beyond that is anyone’s guess.

The PMI Factor

With so many options for a lesser down payment, why do some people insist on putting 20 percent down? In a word, PMI. If you take out a mortgage loan for more than 80 percent of the home’s value, you will have to pay for private mortgage insurance (PMI) on the loan. This insurance is mandatory whenever a single loan has a loan-to-value ratio above 80 percent. PMI protects the lender from losses resulting from a default situation, when the borrower stops making payments for some reason.

[See also: A Buyer’s Guide to PMI]

The amount you pay in PMI will depend on the size of your loan, primarily. For a loan of $200,000 or more, you could easily pay an extra $100 per month in mortgage insurance (or more). This is why many home buyers who can afford a 20-percent down payment are willing to make one. It eliminates the extra cost of PMI.

Note: There are situations where you can make a down payment of less than 20 percent while avoiding PMI. For example, you could combine a first and second mortgage loan for 80 and 15 percent of the purchase price. You could then put 5 percent down to reach 100 percent of the sale price. In this scenario (known as a piggyback loan), neither of the mortgages accounts for more than 80 percent of the purchase price. So PMI isn’t needed.

Recap: 20-Percent Down Payment Not Always Necessary

In the beginning of 2011, federal regulators proposed a mandatory minimum down-payment of 20 percent for conforming loans. These proposals led to a backlash of protest from various groups. Currently, there is some high-level discussion about a 10-percent requirement on conforming loans. But nothing has been decided yet. If these changes do take effect, it probably won’t happen in 2012.

In some scenarios, a lender may require 20 percent down. This is often the case with borrowers who pose a higher risk, such as those with lower credit scores and/or larger debt loads. But for the average home buyer, there are ways to minimize the upfront cost of buying a house.

In the next installment of myth-busting mortgage articles, we will discuss credit scores.