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Down Payment Options on Home Purchases

The Mortgage Professor: More questions about down payment requirements

Sept. 10, 2015

By JACK GUTTENTAG The Mortgage Professor - Tribune News Service

Are there any substitutes for a down payment?

In principle, any collateral acceptable to the lender could serve as a substitute for a down payment.

The only such substitute found in the U.S. 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.

Is it wise to withdraw funds from a 401(k) to make a down payment?

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 your job.

The cost of borrowing against your 401(k) 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 401(k) cannot be rolled over into a 401(k) account at a new employer.

Who sets down payment requirements?

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 percent. With the creation of the Federal Housing Administration program in 1934, the requirement fell to 20 percent, 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 requires only 3 percent down.

A similar program for veterans, developed after World War II and administered by the Department of Veterans Affairs, 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 percent. Recently, the agencies reduced their lowest requirement from 5 percent to 3 percent, but not all borrowers are eligible.

Who is and who is not eligible for a 3 percent down payment requirement on loans purchased by the two federal agencies?

You are eligible for 3 percent 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 percent. If the house will be your second home, the requirement jumps to 20 percent. If you are buying the house as an investment, it goes to 25 percent. And if the property has multiple units, the requirement is 35 percent. Many other permutations and combinations can be found on the Fannie Mae website.

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


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 percent mortgage, for example, you earn 4 percent 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.

Understanding Down Payments on Home Purchases (Sept. 3)
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."

About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.

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