I recently read an article on CNBC where the author talked about Bill Gross’s recommendation to lower the down payment requirements for people to purchase homes.
He states that in order for housing to play a role in the recovery, it’s paramount to ease the up-front cash requirements.
This article brings many questions to mind, and I wanted to discuss what would happen if Bill Gross had his way.
Yes Reduced Down Payments Would Increase Housing Demand, BUT
If we lowered the down payment costs to purchase a home, indeed housing demand would increase. The less it costs to purchase a home, the easier it makes for people to purchase. Pretty simple logic.
BUT, and this is a big but, wouldn’t we be stuck in the same situation as we were during the bubble?
Putting people in homes without any money down has shown how that can backfire. If prices start to decline, people become underwater, they panic, and will walk away from their obligations. People that didn’t have money invested into a home were much more likely to walk away than people with 20% or more in equity.
These walk aways set off more foreclosures and increased inventory; which reduced demand causing home prices to decline further. If these buyers were required to put 20% down, two things would be completely different today.
First – The housing boom wouldn’t have been so enormous as they wouldn’t have been able to purchase a home in the first place.
Second – People with equity tied up into a home would be more reluctant to just walk away.
If your house was worth 10-15% less yet still had 5% equity, wouldn’t you do everything you could to salvage that money? You bet you would. You wouldn’t gut the home and walkaway leaving it to foreclosure.
Purchase A Home You Can Afford
Little to no down payment gives someone the opportunity to purchase a home they can’t afford. Someone making 40k a year should not be able to afford a $350k home. It’s just not reasonable.
Instead, if they had to save up a 20% down payment, they wouldn’t even think about purchasing that home. They would think about purchasing a home they could afford.
If banks were to remove the down payment requirement for a home many people would overextend themselves purchasing a home they wouldn’t be able to afford. This is the number one reason the bubble got so big so fast and fell so hard so fast.
Many people have blamed the bubble and the burst on the sub-prime loan fiasco and loans with complex terms with low initial interest rates. But an article in The Wall Street Journal indicated that there’s more to the story.
According to the article, 51% of all foreclosed homes in the last half of 2008 had prime loans with no equity. Which brings me to my next point:
What Is The Real Reason For The Market Decline?
(Graphic From Wall Street Journal Article)
This graphic shows that the majority (415,319 compared to 393,086) of the foreclosures in the second half of 2008 were directly related to how much equity a homeowner had.
The data clearly shows that the reason the housing bubble got so big and crashed so hard, was because of the ease in which people were able to buy homes with “no skin in the game.”
If we take away the amount of borrowers who bought a home with little money down or without equity, we would decrease the foreclosure rate by 47%.
Keep Lending Standards Tight Even Though It Hurts
If we want to see a true recovery we must learn from the past. People like Bill Gross don’t have a clue.
The suggestion to allow people to put less money down when purchasing a home would throw us into another steep bubble followed by another steep decline in the near future.
It’s absolutely absurd to think lower down payments would be beneficial long term to the housing recovery. Instead, we need to keep down payments as the #1 requirement for purchasing a home. If this would have been the case pre-collapse, we may not even be in this mess.
It hurts right now, trust me I know, but incomes and credit scores will change over time. Just because a borrower has the income one year doesn’t mean they will the next. Equity provides a real incentive for a homeowner to do whatever possible to keep from going into foreclosure.
Instead of gutting the home then walking away letting the home go into foreclosure. A homeowner with equity would try to sell and retain as much as they can. This would reduce the amount of foreclosures, which would reduce the decline.
I am not saying the whole reason we are in this mess is because of no down payment loans. What I am saying is: This all happened because people, banks included, all thought they could get away with it with very little consequence if things went bad. Foreclosure is not a sufficient deterrent if they were starting from nothing in the first place.
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