A good example of this type of messaging can be found in this article just published by the NY Times.  I also received an e-mail from a friend of mine recently who works as a realtor who was essentially making the same argument.

While their logic is not entirely flawed, those who encourage the purchase of a home NOW rather than later in this manner are really only taking into account two factors – interest rates and home values.  But in a home purchase decision, there are a variety of other factors involved that should be taken into consideration.

From a financial perspective, probably the most important other factor would be the amount of down payment a home buyer has ready as they buy a house.  I performed an analysis below where I demonstrate that if a prospective home buyer does NOT have a substantial down payment to bring to the table but, at the advice of the real estate gurus in the market rushes to buy a home now in order to take advantage of stellar interest rates, what happens?  Well, in that case their monthly payment and total amount paid for the home will be HIGHER than if they had waited to save a 20% down payment and suffered a 1% higher interest rate as a result of waiting.

Examine this chart closely, which takes a hypothetical look at the purchase of a $200,000 home in various down payment and interest rate scenarios:

Scenario 1 represents a buyer who rushes to buy a house in order to take advantage of current low interest rates (which are around 5%), but buys the house with little down (5% in this example, likely the minimum down payment their bank required).  It is the most expensive option on the chart, as illustrated by the highlighting of the payments/costs in red.  The least expensive option is Scenario 3 — by all means, take advantage of lower interest rates now if you do have a substantial down payment saved up (20% in this example).  But note that Scenario 2 assumes the worst with interest rates — a full 1% increase, something that recently hasn’t happened very quickly — and yet demonstrates a strong 20% down payment on the part of the home buyer.  And yet Scenario 2 leads to a lower monthly payment and total home cost than Scenario 1.  My point is proven!

There are two other factors to consider that I believe make my case even stronger:

1. Although 5% is a common current conventional 30-year mortgage rate, a higher rate would normally be charged for a non-conventional loan (a loan with less than a 20% down payment), and/or mortgage protection insurance would be required by the lender, making the home buyer’s cost even higher, further reducing the benefit of the lower rate they are receiving.
2. The higher the cost/value of the home, the LARGER the gap grows and the MORE advantageous it becomes to save up a down payment INSTEAD OF jumping in now with little down payment but at a lower interest rate.  Above, the difference in the 15-year mortgage monthly payment in Scenario 2 is $153/month ($1,503 minus $1,350).  But purchase of a $300,000 home, with the same percentage down payment and interest rate assumptions, will increase that gap to $229/month!

Although unrelated to the down payment issue, I think it’s also important to point out that my chart (for simplicity’s sake) assumes the same interest rate for a 15-year and 30-year mortgage, even though in reality you can get about a 0.60% LOWER interest rate on a 15-year mortgage than on a 30-year mortgage.

I hope that I have sufficiently demonstrated that one must tread carefully when taking the advice of the real estate community in regards to the timing of when you should you buy a house as it relates to interest rates, home prices, etc.  When do I think someone should buy a house?  Outside of home market price considerations, my answer would be to buy when they have saved up a substantial down payment and have demonstrated by doing so that they can live within their means and afford the monthly payment of the house they wish to purchase.

For a more exhaustive treatment of the argument behind saving up a substantial down payment, see my blog post “Saving for a home down payment: 4 BENEFITS”.

Not that any of these things are bad in and of themselves, but I think it may have planted some ideas in the minds of mortgage-burdened homeowners that were likely not intended.

As explained by this article in the San Francisco Business Times, a TransUnion study found that the percentage of homeowners deliquent on their mortgages but were current on credit card obligations increased, while the percentage of individuals in the opposite scenario (current on their mortgages but delinquent on credit card obligations) increased.

Contrary to the conventional wisdom that individuals will tend to favor secured loans/credit (such as debt secured by a home or a car) over unsecured debt (credit card debt, for example) when it comes to staying current on payments. But this new evidence suggests that the trend is reversing.

Why? There are a few reasons this could be occuring:

1. The speed of creditor retribution is much slower and much less dramatic with a mortgage than with a credit card.  A deliquent mortgage payment may result in phone calls, but the ultimate penalty (foreclosure and the eviction that comes with it) is literally months away from the first missed payment, and with banks eager to avoid foreclosure in many cases, homeowners know they will likely have many opportunities to make things right.  On the other hand, credit card companies quickly hit cardholders with late fees for missed payments, not to mention the ongoing interest charges on their balance, often which are at a very high percentage.
2. Credit cards are “helpful” to meet ongoing living expenses.  If their ability to spend via credit cards is cut off, desperate consumers may be unable to buy groceries or put gas in their vehicles.  It makes a lot of sense in the short-term to make a minimum credit card payment and keep the card open for ongoing spending if they are struggling to meet base-level needs such as food for the family.
3. Homeowners deliquent on their mortgages are beginning to “call the bluff” of the banks.  As mentioned a moment ago, all of the press coverage on the issue of mortgages gone bad and looming foreclosures may have made many homeowners disbelieving that their bank will ever actually foreclose on THEM.
4. Homeowners have lost hope.  With home price depreciation not reversing any time soon in many markets, recent owners of highly-leveraged homes don’t see any path to getting into positive equity territory any time soon.  It could be argued that many homeowners consider foreclosure inevitable, so why continue to make payments?

As much as I loathe and discourage consumer (credit card) debt, vehicle debt, and highly-leveraged home ownership, the trend indicated by the TransUnion study is not surprising.

Creditors and consumers alike would be wise to think through the implications of this trend on their current and future practices.

This product, for a percentage point or two of the value of the home when purchased, will insure you against loss of value.

The companies offering this product, I would guess, are betting the success of this product on a couple of strategic assumptions:

1.  It assumes that there is a decent chance that a home buyer is only considering staying in their home a short period of time, probably 5 years or less, before moving to a different city, a different place in their city, or to a larger home.  If someone plans to move in just a few short years, they may be more likely to purchase this insurance to protect the potential “down side” they would experience if their local housing market tanked and their house plummeted in value right as they were needing to sell it.  Rather than having to come up with funds out of pocket, this insurance plan would provide for them.

2.  The plans are catering to buyers with little down payment.  While most home buyers with substantial down payments would never dream of buying home value insurance, individuals with little or no down payment often understand the risk they are taking and would like to have a way to mitigate that risk.  They don’t want to find themselves in the same situation as their old neighbor, or as their near-bankrupt relatives who paid dearly to sell a depreciated house they couldn’t afford due a simultaneous drop in the housing market and loss of their own job and income.

While home value insurance may be helpful for some, if you buy a home you plan to live in for a while– and if you buy it with a decent down payment, there’s no need for these products and it adds yet more costs related to the home purchase transaction.  Ironically, one of the major arguments to staying in a house for a while before selling is that the real estate transaction cost incurred when you sell makes up a smaller percentage of your home’s equity than it would over a longer period of time. And yet this product, which itself aims to protect your equity position in your home, just adds to that cost burden.

It will be interesting to see how these products progress — will insurance regulators step in to regulate these products as what they are (insurance!), and what will be the opinion of personal financial coaches and advisors are on these products in the coming years…?  Time will tell.

Mortgage fraud aside, however, one still might ask “is there really anything wrong with a $0 money-down mortgage?”

If by “wrong” you mean something inethical or morally wrong, then probably not, of course.  If by “wrong” you mean ill-advised, then I would say YES it is ill-advised.  Many financial counselors and planners alike have recommended sizable down payments forever, and yet many (usually those looking to buy a house with little cash) write off the advice as “legalistic” or “not practical”.

Instead of chiding those of you who have taken the $0 down or minimal down payment approach (because I too have done the $0-down thing in my less-informed past, though I’m now free of such an arrangement), let me instead focus here on FOUR BENEFITS of saving for a down payment.

There are other issues with home mortgages of course – how long of a mortgage do you get, is it possible to put too MUCH money down on a house, etc. — but those I will save to discuss another time.  For now I’ll stick to my discussion on the benefits of saving up a down payment.

BENEFIT #1:  IT LIMITS THE AMOUNT OF HOUSE  YOU BUY TO A DOLLAR AMOUNT WITHIN YOUR BUDGET

There is some scary reverse psychology that most Americans have bought into (pun intended) that goes something like this– “the less I have to put down on a purchase (car, house, etc.), the better I can afford it!”.  In fact, the OPPOSITE is true.  The very fact you cannot save money to place down on the purchase should give you pause, and make you wonder if you can afford the monthly payments on the new purchase.

But when you force yourself to save money down for a house, you automatically limit the value of the house you can buy to the value of a house you can actually afford.  I, along with many personal finance coaches, recommend you save up a down payment of at least 20% of the home’s value, and preferably, another 5% or so to fund new furnishings, minor improvements, etc. that each new homeowner inevitably wants (financial planner Dennis Stearns, according to this article, claims new homeowners on average spend 3.6% to 4.5% of the value of a recently purchased home on improvements alone).  Note that this total 25% home savings should be beyond what you would hold in your emergency fund (typically made up of 3-6 months worth of expenses).  Some might argue that a base down payment of 20% (plus improvement/move-in costs) is excessive, and that one can lower their risk and mortgage payment by saving up 10% or 15%.  While that is certainly true, and while doing so is better than putting down no money at all, I explain below an additional benefit of saving a full 20% — avoiding the cost of private mortgage insurance, or PMI.

Let’s look at an example of how this actually works out.

A- Let’s assume your family has a household income of $75,000, resulting in net “take home” pay of about $55,000 (assuming a couple of kids and typical deductions).

B- You would like to purchase a house in an area that will cost you somewhere in the range of $200,000.

C- According to my recommendation, you would need to save up about $50,000.  If you as a family are able to save 15% of your take-home pay, or $8,250, then at that pace if would take you about 6 years to save up for a down payment.

D- If that makes you say “yikes, six years!” then you can either attempt to save up more quickly, or scale down your plans in terms of price/size of house.  If you instead aim at a $150,000 house, you could save up the 25% for down payment and initial expenses of $37,500 in about 4 1/2 years.  Cut spending and save a bit more, for example save 20% of your take-home pay ($11,000 per year) and you could have 25% of a $150,000 house saved up and be ready to buy such a house in about 3 1/2 years.

Ultimately, most people will find that the closer to 2 or 2.5 times their annual gross income the price of their house is, the more likely they will be able to save for a down payment, and then make the payments on that house successfully.

Unfortunately, the mortgage world is still full of lenders that will loan you 95% or 100% of the value of your house and who would often like to sell you a house costing 3 to 4 times your annual gross income.  Think about it – mortgage brokers are typically paid a percentage of the loan amount, so the more they can get you to borrow, the better off they are!

BENEFIT #2:  IT LOWERS THE CHANCE THAT FUTURE FINANCIAL DIFFICULTIES WILL DEVASTATE YOUR FINANCIAL WORLD

When you have 20% or greater equity in your home from day one of your ownership you lower the odds that your mortgage payment will contribute to future financial devastation of your family.  There is both a direct and indirect reason for this:

INDIRECTLY, by getting into a financial position of saving for your home purchase, you are unlikely to fall behind on your mortgage payments due to overspending as you had to create a disciplined financial environment in your family in order to save for the purchase to begin with.

DIRECTLY speaking, with ownership in a home that is worth substantially more than the debt you have on it, you have a “cushion” of net worth that can be accessed.  Although equity loans are certainly available and though I recommend against them, the main thing I have in mind here is that should severe financial difficulty affect your family (such as a loss of all family income), and you burn through your several months of emergency funds and are still struggling, you could sell your home quickly at a good price and still come out with some cash in hand.  Families who owe almost as much on their home as its value of their home, or who owe even more than the home’s value, put themselves at significant risk in the event their income drops or disappears altogether.  Another DIRECT reason for the benefit of having equity in your home is that, in the event that life circumstances change and require you to move to another part of your city, or another city altogether, it is unlikely that property values will drop by more than 20% and so even though it will not be pleasant, you WILL be able to sell your house if you absolutely must.

BENEFIT #3:  IT LOWERS YOUR MORTGAGE PAYMENT!!

See the chart to the right, which demonstrates the difference in monthly payments (loan principal + interest only) on a mortgage with 20% down as compared to 5% down (assumes 5% interest rate and a 15-year term).  Note the substantial payment difference with the home values ($150,000-$200,000) used in our example above — there’s hundreds of dollars of monthly difference in the payments!  And of course the difference grows even larger as the size of the home grows.

This is an obvious benefit that I don’t think many people think about when weighing the idea of a small vs. a more substantial down payment.  However, it should be one of the leading factors to consider!  This is because, although during the period of time in which you save up for your house down payment there could be some fluctuation in your budget and savings from month-to-month, once you’re locked into a mortgage, there will be no mercy coming from your lender — you’ll have to make the payment every month.  If you’re going to be locked into a large monthly payment for probably at least 15 years, doesn’t it make sense that the payment be smaller if you can help make it so?  The only other way to shrink the size of your payment is to a) go for a less expensive home– a good solution for some, or b) use a longer-term mortgage — not as good of a solution but also not a topic I will get into here.  Finally, it is also critical to understand that by having a loan amount of 95% of the value of a $150,000 home, you will pay about $32,000 more in total over 15 years for the house (as a result of the extra interest on the extra borrowed amount) than you would with a larger 20% down payment.

The bottom line on my third point here is this:  every dollar saved NOW for a down payment on a house is a dollar that you won’t have to pay someone later– with compounded interest.

BENEFIT #4:  YES, IT ALSO ELIMINATES THE COST OF PRIVATE MORTGAGE INSURANCE (PMI)

Private Mortgage Insurance, or PMI, is a type of insurance lenders require homebuyers with small down payments to acquire in order to protect the banks against the chance the home buyer will be unable to make their mortgage payments.  The fact that a bank would require you to buy insurance to protect them from you should raise red flags — because THEY apparently believe the odds of you at some point losing your ability to pay your mortgage are higher odds than YOU think they are, if you’re willing to get a mortgage despite this extra requirement!

PMI, according to AppraisalToday.com, is typically required when a home buyer brings a down payment of less than 20% of the home’s value.  To illustrate the cost of PMI, the same source says that with 5% down, you would pay about $70 per month for PMI on a 30-year mortgage on a $119,000 home.

This cost can be completely avoided with a down payment of at least 20%.

Unfortunately, in recent years when people talk about “avoiding PMI” they are typically promoting an arrangement involving a 80% primary mortgage and a second mortgage ranging from 15-20% of the remaining value, thereby removing the need for PMI.  For those who have taken this approach, however, they realize that they pay a higher rate of interest (often at variable rates that adjust periodically) on their second mortgage, and typically incur additional financing-related fees at the time of purchase.

CONCLUSION

It is challenging, from a purely financial and risk reduction standpoint, to make an argument for little-or-no-money-down home loans.  And yet, the mortgage industry has made such an argument to do so convincingly, in an effort to drum up more of the commissions and fees they generate for originating a mortgage.  The sub-prime collapse and housing market meltdown in general in recent years has brought this further to the forefront of public understanding, and yet mortgage products featuring little or no down payments are still prevalent today for those with decent credit and income — and so do not assume the marketplace is protecting everyone now from every bad financial product out there; I would encourage each of you to think twice before embracing such products.

Chances are, those of you who have bought homes with little or no money down (or are considering doing so) are not making the decision based on numbers or risk, either.   It’s an emotional decision for you; you WANT a new home and so you’re willing to ignore the risks to get into that new home.

But I can assure you this — if times get hard for you financially after doing so, the grief that will come from the financial stress of a mortgage payment on a house you can’t afford the payments on, and can’t sell because you owe as much as it’s worth will far outweigh the joy of that new kitchen with granite counter tops and crown molding.  Why put yourself through years of stress trying to get out of the house or make money to stay in it?  Instead of suffering later, sacrifice NOW for a few years to avoid such a situation.  I promise that it will be well worth it!

In 17 locations around the U.S., many made up of small cities surrounded by large rural areas, 50% or more of home owners own their homes outright and therefore don’t have to worry about rising monthly payments or owing more than their home is worth, according to a USA Today analysis of Census data. In 123 areas, 40% or more don’t have a mortgage, and nationwide the average is almost a third. The analysis shows that areas containing higher percentages of zero-mortgage home owners are scattered across the country, from Somerset and Johnstown, Pa., to Lumberton, N.C., Sebring, Fla., and Lufkin, Texas. Most have a central city of fewer than 50,000 people. Higher percentages of mortgage-free home owners are less likely in rapidly growing areas such as Washington, D.C. (17%), Atlanta (19%) and Las Vegas (20%). Many of the places that have a high share of no-mortgage home owners never enjoyed the boom that sent housing prices soaring across much of the nation. As a result, there was no bubble to burst. “Not always do we have the best of times, nor the worst of times,” says Mark Henne, city manager in Bluefield, W.Va., a coal country town that ranks at the top with 57% of its home owners mortgage-free. “We’re not experiencing the defaults that the rest of the country is.” [Emphasis added]

- USA Today (“Some Parts of U.S. Escape Housing Mess”, 11/17/08)

In order to have paid down mortgage balances without maxing the equity right back out for merchandise, cars, or home improvements, Bluefield’s residents have undoubtedly done without some of the things others wouldn’t dream of living without. In fact, the path to financial stability is costly, particularly in the short run. But, as I will continue to argue in this blog, well worth the cost.