When size really matters: your down payment

December 17, 9:44 AMHousing ExaminerDena Kouremetis

There are few things more changeable these days than the mortgage market. Borrowers must now take note of one of the most important changes, however; the tightening of underwriting requirements by  lending institutions that translate into  higher down payments.

Down payment size has been and no doubt will continue to be the bellwether on which lenders will place their bets to assure that loans will be paid off.  The real estate community may refer to it as your “initial investment,” but the bottom line is that the down payment in a home purchase is the difference between the sales price of the property and the amount of the mortgage loan (secured by the property).

When you’ve just purchased a home, therefore, your down payment can be described as the only equity you have in your new digs. While equity can fluctuate from the time of your initial purchase, it is from then on measured by the difference between the current value of your home and the current loan balance.

A good way to illustrate the importance of the down payment to the lender is to think about an imaginary Vinny. Vinny owes Sluggo $40,000 for a car.  Sluggo snarls and says, “Pay up now or take a dirt nap.”  Vinny runs to the trunk of his car and pulls out a briefcase.  “Yo, Sluggo, I got $4,000 I can give you now, and if you come around once a month, I’ll give you a little more each month.  Will that do?”

Sluggo nods his head slowly.  “Yeh, but it’s gonna cost you. I want it back with 10% interest.”

Vinny, not knowing his financial future, but confident that he can somehow come up with payment says, “Sure, sure, Sluggo. Not a problem.”  Vinny knows that by the time he pays off the loan (if he does), his car will be worth much less, but the risk is worth it to him to have a great set of wheels.

Today’s banks aren’t as mean as Sluggo, but many of yesterday’s borrowers (some of which have lost their homes by now) are risk takers of the Vinny variety, having offered a small down payment while betting on finding ways to pay the rest back each month. In the financial abyss in which the country finds itself, however, banks have reverted back to the strict guidelines of the 1980s and earlier.  They realize once again that the down payment is the single most vital factor affecting their potential loss, considering it a buffer in the event of a foreclosure.  The bigger the down payment, then, the less risk they take.

To top it off, borrowers who get into payment difficulties but have equity in their properties usually will try to sell to avoid foreclosure, at least hoping to walk away with some equity rather than hand it all back to the bank while avoiding the costs of a foreclosure.

Another reason why lenders attach so much importance to the down payment is that they assume that 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. But don’t assume you can borrow any or all of the down payment against your VISA card.  Underwriters look for evidence that the funds committed to down payment are your own and have been “seasoned” for a while in an account.  They know well how to conduct a paper trail, combing through your bank accounts and credit card history to see just how you accumulated the money.

From 2000-2006, housing prices in some metropolitan areas rose by more than 20 percent a year. If a home buyer had put nothing down (which was possible at the time), that 20 percent appreciation in home values meant that he would have as much equity in his property as a buyer who came up with cold, hard cash for a 20 percent down payment.  

Run the VCR forward to 2007-2008 and that boom equity period from just a year or so earlier was a direct result of an ill-advised weakening of underwriting requirements in general -- and down payment requirements in particular.

So lender requirements for home loans had to be drastically revamped. Rising prices may generate homeowner equity, but falling prices destroy it.  In fact, a VA loan is the closest you can come to a zero-down loan. 

FHA loans remain available at 3 percent down for smaller amounts, and conventional loans now generally require at least 10 percent down (accompanied by a hefty mortgage insurance payment each month), although the good old 20% down is much more common.  On top of this, lenders now want most borrowers to have good credit scores and to fully document their incomes.

But hey – it could be a lot worse.  Ask around when you travel abroad and you’ll find that American lenders are still some of the most generous when it comes to loan requirements.

So what have we learned here?  Our parents or grandparents’ generation, considered by many to have been the “greatest generation” of all, had it right all along.  Save your money, take as few risks as possible, and good things will come.  It seems the Baby Boomers’  “have it all now” mentality is quickly undergoing a lobotomy.  And Sluggo isn’t the guy with the scalpel.