Bank of America CEO Brian Moynihan recently talked about lowering the standard downpayment on homes to 10% from 20%. If applied, it could certainly boost homebuying by millennials whose homeownership rate is the lowest among the five age groups.
Pending the mortgage industry’s action on Mr. Moynihan’s suggestion, let’s discuss the role the size of downpayment plays in today’s mortgages.
The 20-Percent Downpayment Standard
Mr. Moynihan in an interview with CNBC believes that the move to lower the standard downpayment would not introduce much risk to lenders but would help more consumers get mortgages.
While lenders and mortgage programs as discussed below require varying downpayment sizes, 20 percent of the home’s purchase price is considered a gold standard in the industry. This rule is based on the guidelines set by government-sponsored entities, Fannie Mae and Freddie Mac.
So that lenders can sell their mortgages to either GSE, they must conform to their underwriting standards, downpayment and all. Fannie and Freddie are the biggest purchasers of mortgages in the U.S., selling to either entity will enable lenders to recoup funds they can lend to other borrowers.
Putting 20% of the home’s purchase price is beneficial to homeowners, too.
- There’s no private mortgage insurance. An insurance meant to protect the lenders in the event of default, PMI is separate from the compulsory homeowner’s insurance. The PMI may be added to your monthly mortgage premium, paid upfront or both as required by the lender.
- There’s a higher chance of getting approved. A higher downpayment lowers the risk for the lender to make the loan. A big plus, so to speak, to your loan application.
- There’s a smaller loan to take out. With you contributing 20% of the home’s price tag, you’ll only be borrowing the remaining 80%. This lessens your monthly payment. Say you take out a 30-year loan on a home worth $200,000 and then put down 20% ($40,000) at 4.02%, you’ll get a monthly payment of $766. With a 0% down, your monthly payment will be $957.
- There’s a lower interest rate to pay for borrowing. Because of the lower loan amount, thus the lower risk for the lender, a mortgage with a 20-percent down has a lower interest rate.
- There’s equity already stored in the home. Equity is pretty handy when you refinance your existing mortgage and do a cash-out refi. Having a 20% equity early on in the home can help mitigate the ill effects of declining home values.
Less Than 20%?
For all its benefits, the 20-percent standard can be too high a hurdle for homebuyers to overcome. Partly to encourage more first-time homebuyers, there are mortgage programs that ask a downpayment below that threshold.
First off our list are low-downpayment mortgages from FHA. Its mortgages can require as little as 3.5% of the purchase price. FHA loans are also lenient to first-time homebuyers with not-so-high scores and high debt-to-income ratios. An FHA loan has mortgage insurance premiums, which are paid upfront and on a monthly basis.
Then there are conforming loans specially made for first-time homebuyers from Fannie Mae’s HomeReady™ with 3% down and Freddie Mac’s Home Possible™ with 3% to 5% downpayments.
Conventional loans, which don’t conform to GSE standards and not part of government programs, can also be taken out with less than 20% down. You’ll need a PMI though.
Who would forget 100-percent mortgage financing for veterans and families in rural areas? The VA and USDA loans require little to no downpayments to better serve their targeted demographics. Each loan program does not require a mortgage insurance but a funding fee for VA loans and a guarantee fee for USDA loans, respectively to cover losses in the event of default.