By Jack Guttentag
Saturday, August 30, 2008

Over the past year, the mortgage market has changed more rapidly than in any comparable period since the Great Depression. From the standpoint of borrowers, two changes are of paramount importance.

The first is an increase in day-to-day price volatility, which I wrote about a few weeks ago. The second is a tightening of underwriting standards, with higher down payment requirements the centerpiece.

Underwriting requirements are the rules lenders impose to assure that loans will be paid off, and the down payment has always been the most important of them. If you buy a house for $200,000 that is appraised for $200,000 and you take a mortgage of $160,000, your down payment is $40,000, or 20 percent of the value.

A 20 percent down payment can also be described as the borrower having 20 percent equity in the property. Equity is the difference between the value of the property and the loan balance, both of which are likely to change over time.

One reason the down payment is so important is that it is the single biggest factor affecting loss to the lender in a foreclosure. For example, if foreclosure costs are 20 percent of value and the property value does not change, a 20 percent down payment fully protects a lender against loss, but a 10 percent down payment provides only partial protection.

Perhaps even more important, borrowers who get into payment difficulties but have equity in their property usually will sell to avoid foreclosure. By selling, they realize the equity themselves, whereas if they allow the property to go to foreclosure the equity will be depleted by foreclosure costs. The sale avoids the foreclosure.

There is another reason lenders place so much importance on the down payment. Borrowers who have been able to save for a down payment are less likely to get into trouble later. Saving that money requires budgetary discipline; repaying a mortgage also requires budgetary discipline, and the one carries over to the other.

Of course, this assumes that the down payment is saved, not borrowed. Underwriters look for evidence that the funds committed to a down payment are the borrower's own.

When a purchase is made, the owner's equity is the down payment, but as time passes the equity is affected by other things.

One is any change in the loan balance. If the mortgage is "fully amortizing," the mortgage payment includes some principal, which reduces the loan balance. If the required payment is interest-only and the borrower does not add anything to the payment, the loan balance will not change. And if it is a negative-amortization loan, the balance will increase rather than decrease, and homeowner equity will decline.

In the first few years of a mortgage's life, however, changes in homeowner equity resulting from changes in the loan balance are usually quite small.

Homeowner equity is also affected by changes in house prices, which can be sizable. From 2000 to 2006, house prices in some areas rose by more than 20 percent a year. If a home buyer puts nothing down, after a year of 20 percent appreciation he has as much equity in his property as a buyer who put 20 percent down in a stable market.

It is hardly surprising that house-price inflation during the go-go period resulted in a drastic weakening of underwriting requirements in general and down payment requirements in particular. Zero-down loans became increasingly common.

Just as rising prices generate homeowner equity, falling prices destroy it. When the market turned and home prices began to decline, down payment requirements were drastically revamped.

There are no zero-down loans anymore, except those from the Department of Veterans Affairs. Federal Housing Administration loans remain available at 3 percent down, but conventional loans now generally require 10 percent down, and in some areas more. On top of this, lenders now want most borrowers to have good credit scores and to fully document their incomes.

Down payment requirements have a critical impact on the ability of people to afford a house. If buying is in your plans but you have never been able to save, it is time you learn how. The secret is to give saving high priority in your budget.

Decide what part of your income you can afford to save, and create a special account. Immediately after you are paid, write a check to that account. If you view saving as a residual -- what remains of your income unspent at the end of the month -- you are giving saving the lowest possible priority, which practically guarantees failure.

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,http://www.mtgprofessor.com.

© 2008 Jack Guttentag

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