How Big Will Your Downpayment Be?

Last Tuesday (Oct 28th), President Bush's first Treasury Secretary Paul O'Neill put forth the proposal that Congress forget about the new economic stimulus package idea and instead concentrate their efforts to push through a law that will mandate a minimum downpayment threshold for prospective homebuyers. In other words, if a homebuyer does not have downpayment funds at least equal to 20% of the anticipated purchase price, they should not even think about applying for a home loan.

So, are you in the market to buy a home? How big will your downpayment be?

O'Neill believes that we wouldn't be in this credit/economic mess if home lenders stuck with the old tried-and-true 20% downpayment rule. He said that in 2006, 30% of all mortgages were zero-down and among those buyers, an even larger amount defaulted on their very first mortgage payment. It should have been obvious long before now that too many buyers could not afford the loans they were approved for. As such, homes loans should be reserved for only those buyers that can afford to put down 20% towards a home purchase. O'Neill is certain that while this may not be good for some businesses in the short term, it will be good for the overall economy in the long run.

The number 20 has long been the "magic" number in the banking industry because the research showed this to be the threshold where the lending risks most favored the bank. If, for whatever reason, the home did wind up in foreclosure, the bank could price the home at a deep enough discount to attract a quick sale. (This is why foreclosures continue to be perceived as great deals - even this market.) It was, therefore, in the bank's best interest to have as much of a buffer as possible in the event of a foreclosure.

For a some time, if you wanted to buy a home, you were going to have to save up and/or borrow the money to make it happen. This was impossible for some and difficult for most. However, as home values started to increase, so too did the home loan options available to homebuyers. Buying a home with 20% down was no longer the rule. Instead, a buyer could use private mortgage insurance or piggy-back loans to make the deal happen. With these options, buyers were even able to finance 100% (or as high as 125%) of the purchase price. Banks were now able to make much more money from home loans than before. Loan requirements that were once strict and available to just a few buyers became too lenient and available to too many of the wrong ones.

O'Neill contends that enacting this 20% downpayment law will be the quickest way to shore up the nation's economy. He is critical of the presidential campaigns of both Sen. Obama and Sen. McCain, neither of whom has endorsed this idea. O'Neill is not surprised by this. And I say, he shouldn't be. It is a terrible idea.

Homeownership is a highly-regarded financial planning tool and has long been recognized as the best way for the vast majority of people to build personal wealth. By leveraging a loan, a person is able to earn all of the appreciation and enjoy all of the financial benefits homeownership provides. More importantly, because homeownership is best as a long-term investment, if a person can afford to own a home now, it would behoove him/her to buy as early on in their lives as personal circumstance would allow.

The type of legislation that O'Neill is proposing may look good on paper, but one can not legislate a one-size-fits-all mortgage product and expect good things to happen. I'm willing to bet that it will hurt homebuyers - the middle class and working poor in particular - far more than it will hurt any business. O'Neill should give more consideration to the many buyers who are, in fact, a good credit risk even without having saved 20% to put towards a downpayment.

This is a complicated problem that will require careful consideration of many factors in order to find a workable solution. If homeownership is really part of the American Dream, Congress should work to give everyone a fair opportunity to achieve it. How big will your downpayment be? No law should ever affect the answer to that question.