The Low-Down on Low Down Payments

by Dianne Molvig

Like many people hoping to buy a home someday, you may have doubts whether you'll ever be able to afford it. Sure, you have a stable job and earn a good income. Your credit history is sound, and you've managed to save a little to cover emergencies.

The missing piece of the puzzle is the extra savings you'd need for the down payment, which can be a hefty sum with today's housing prices. You're thinking it will be years before you save enough--if you ever do. If prices climb even higher, the dream of home ownership might continue to be just beyond your reach.

On the other hand, you know that right now a monthly mortgage payment wouldn't be that much more than what you're spending on rent. But short of moving into a tent so you could sock away all your rent money for a down payment, there seems to be no way out of this predicament.

Or is there?

More options than ever

Lenders used to require borrowers to pay at least 20% down on the purchase price of a house to qualify for a mortgage. That 20% requirement is history, as down-payment minimums have nudged steadily downward over the years ... to 5%, 3%, and even 0%.

In fact, some lenders offer 103% financing, which means the buyer can borrow the full purchase price of the house, plus 3% to cover closing costs--that is, the costs associated with closing the sale of the house. Thus, today a buyer might be able to get a mortgage without paying anything out of pocket.

With this trend, many prospective buyers are finding that home ownership is within their grasp, after all. Should you consider a no- or low-down-payment mortgage? It seems like a great deal. And because you're putting little or no money down, what do you have to lose?

Plenty, if you default on the loan, points out Jack Harris, research economist at the Real Estate Center at Texas A&M University, College Station. "First of all, it will be on your credit rating," he explains, "and that may prevent you from buying another house for a good long while. Also, lenders used to write off mortgage losses, but now they'll come after you to recover any deficiencies" between the sales price of the house and the mortgage balance you owe.

In considering a no- or low-down-payment mortgage, Harris advises consumers to keep in mind one basic fact of life to avoid getting carried away. "A lower down payment," he points out, "just means you're borrowing more money. It doesn't mean you're getting anything for free."

But, "good credit" has different definitions, depending on your lender, so don't hesitate to apply. If a lender says no, ask for guidance about how to improve your chances next time.

Prime candidates

Still, a no- or low-down-payment mortgage may be a smart move for some. For first-time home buyers, this may be the only way they can get into a house and start to build equity. Equity rises as you pay off principal on the mortgage--although most of your payment goes toward interest in the early years--and as the house appreciates in value.

Bear in mind, though, that rising values are "not a sure thing," Harris says, "particularly in today's market. I think the big rises in value are probably over, except in certain markets."

Another potential candidate for this type of mortgage, Harris suggests, might be someone who buys a fixer-upper. Instead of putting money down, the buyer can use that cash to make improvements and increase the house's value--and the buyer's equity.

You also might consider this option if you have somewhere better to invest your money, such as a sound investment earning a higher interest rate than your mortgage rate. For instance, at GTE Federal Credit Union, Tampa, Fla., some retiree members have opted for no or low down payments, according to Rory Ferrell, mortgage production supervisor. "They don't want to dip into their 401(k) or IRA," she explains.

Still, if you have the funds to make a down payment, that's probably the wisest move, advises Lou Anne Bigaouette, GTE Federal's director of mortgage lending. "I'd rather put that money down," she says, "and make my payments less each month. And if I can avoid private mortgage insurance, I'd rather do that, too."

Often you'll have to pay private mortgage insurance, or PMI, if you put less than 20% down (some programs drop this requirement). PMI insures the lender against loss in case the borrower defaults. The PMI premium adds an amount to the borrower's monthly mortgage payment.

Right for you?

There's no way around it. A zero or low down payment translates into higher monthly mortgage payments, as well as a higher interest rate. The lender will assess your ability to meet those payments before qualifying you for the loan. But regardless of what the guidelines may say you can afford, you must decide how big a payment you can live with comfortably.

It's a good idea, however, to get the lender's preapproval, as well. "I would suggest you get preapproved before you even begin shopping for a house," Ferrell says. "The lender pulls your credit, reviews your income, and gives you a formal approval. Then you know you're safe to go out and shop in that price range."

The process of figuring out what size mortgage you qualify for before you actually apply for a loan is called prequalification. By prequalifying, you know up front what price range you can afford--before you start looking at houses.

Preapproval means you're essentially good to go. You formally apply for the mortgage and pay an application fee. The lender determines that you are eligible for a mortgage of a certain amount.

Shopping around for a mortgage is crucial, too, advises Kelly Schrader, manager of lending and real estate services at Portland (Ore.) Teachers Credit Union. "A lot of times first-time home buyers don't realize what's available," she says, "because there are so many new products. They have options that they didn't have in the past."

Also, compare lenders and different mortgage products from the same lender. Be sure you understand the different options. Will you pay a higher interest rate if you pay less down? Does a low- or no-down payment mortgage carry any additional fees? Does a smaller down payment mean a bigger PMI premium?

"Get a good faith estimate from the various lenders," Bigaouette suggests, "to see all the fees involved." A good faith estimate details all the closing costs.

Remember, your money must stretch to cover not only closing costs and higher monthly payments, but also the costs of owning a home. Major repairs. New furnishings. Maintenance. Schrader suggests attending first-time home-buyer seminars to get the full picture. "That will give you a working knowledge," she says, "of what it will take to be successful once you purchase a home."

August 9, 2004