The Down-Payment Debate: Can You Afford No or Low Down Payments?

In 2005, 43% of first-time home buyers paid no money down when they bought their homes, according to the National Association of Realtors®, Washington, D.C. It's a sign of the times.

With today's high home prices, many first-time buyers simply can't scrape together a down payment. Starter homes in many markets may cost what upscale homes were selling for just a decade ago. A 5% down payment on a $300,000 home would be $15,000, while even a down payment as low as 3% would require $9,000. Many first-time buyers don't have that kind of savings.

What many first-time buyers do have, however, is a good income and an excellent credit record. And their budget has room for a monthly mortgage payment, which may be only a little more than the rent they're currently paying.

Such buyers are strong candidates for no- or low-down-payment mortgages, says Rita Curtin, manager of real estate originations at Wescom Credit Union, Pasadena, Calif.

On the other hand, "The ones who should stay away from these mortgages are people who are just doing this to get into a house," Curtin says, "but they really can't afford that monthly payment."

Test before you leap

When you pay little or nothing down, you increase your monthly mortgage payment because you're borrowing more money. Also, you'll pay a monthly private mortgage insurance (PMI) premium, which is folded into your house payment. The purpose of PMI is to protect the lender against the increased risk of losses when buyers pay less than 20% down, although some loan programs forgo PMI.

The higher monthly payment is the first factor to weigh. Consider, too, that your payment may go even higher in the near future. Some no- or low-down-payment mortgages have a fixed interest rate, but often these products come with an adjustable rate. "If the rate changes a year or two down the road," Curtin points out, "you could have payment shock."

To avoid that, be sure you understand when your rate could go up and by how much. Find out exactly what that rate hike translates into for your monthly payment, Curtin advises, and ask yourself if you can afford it.

"The way to test this," she says, "is to put away that amount of money [equal to the higher payment] every month, minus the rent you're now paying. If you can live like that, then you're ready to do this. If not, you need to save more money for a down payment to make the mortgage amount lower." That also may enable you to qualify for a fixed-rate mortgage.

Avoid fooling yourself

Buyers who purchase a home with little or no money down can succumb to delusional thinking. They assume that if the mortgage payment climbs beyond what they can afford, they'll just sell the house, recoup the costs, and end up back where they started.

But being able to sell the home without losing money "is not a slam dunk," says Allen Fishbein, director of housing and credit policy for the Consumer Federation of America, Washington, D.C.

"It's not automatic," he explains, "that at any given time you'll be able to sell your house and get enough for it to cover all the costs of the mortgage, plus your broker's commission" for selling the house. In fact, all those costs could total more than what you could get for selling your house, and you'd have to make up the difference.

Scenarios such as these didn't worry consumers in the past few years when housing prices kept soaring. But prices are leveling off in many communities. Assuming you'll be able to build equity solely through your home's appreciation "may turn into a fool's paradise," Fishbein says.

Offers too good to refuse?

Adding to the possible pitfalls, Fishbein says, is the fact that no- or low-down-payment options sometimes are combined with other mortgage features. "There's a concern about layered risk when you combine these features," he says. "Borrowers need to consider that, as well. It's not just whether it makes sense to put down as little as possible, but what are the other features of the mortgage product you're taking out?"

For instance, an interest-only mortgage requires the borrower to pay interest only in the early years, thus paying nothing toward the principal and building no equity. With a minimum-payment mortgage, the payment is set low in the early years. But if that payment is so low that it doesn't even cover interest, the loan balance actually grows during those years. This is known as negative amortization. Other mortgages require no documentation to prove the borrower's income when applying. The lender simply takes the word of the borrower, who may be all too tempted to pad the numbers.

Consumers are bombarded with mortgage offers on the Internet, on television, and through other media. It can be difficult to sort out all the various features of these mortgage products. That's why Fishbein recommends seeking independent professional advice when choosing a mortgage that's right for you.

"A lot of mortgage products are being sold by brokers who say, 'What house do you want? How much is it? What do you need to qualify?' Then they start layering these different features on top of one another until they get to a monthly payment the borrower can appear to qualify for," Fishbein says.

Sadly, those borrowers may qualify today, but be in trouble tomorrow. Curtin has seen that happen to some members of her credit union who got mortgages elsewhere. They ended up with a too-hefty monthly payment and no equity in their homes.

Later, they turn to their credit union looking for help out of a financial bind. "We try to help," Curtin says. "And we tell them, 'You should have waited to save more or come to see us first.' "

Still, no- or low-down-payment mortgages can be a sound choice, for the right buyer in the right situation. "But sometimes," Curtin says, "you just need to be patient and wait a year, even two years, until you're really ready, rather than taking the chance of losing the home."

Published April 3, 2006