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The Pros and Cons of New Home Loan Programs

By Stefanie O’Connell from the Daily Capital Blog

 

So many people see homeownership as the fulfillment of the American Dream. Making this dream come true looks like it might be even easier now, as Lending giants Fannie Mae and Freddie Mac have recently introduced mortgage programs that reduce down payments for qualified buyers.

97% LTV Programs

Fannie and Freddie’s programs allow qualified first time buyers and those looking to refinance their primary residence to do so with as little as three percent down. They will be issued a fixed-rate mortgage- also known as a 97 percent LTV (loan-to-value) ratio.

With the housing crisis not yet ten years behind us and its impact still rippling through the economy, these new three percent down payment programs may trigger some skepticism.

But are these new mortgages (and their accompanying requirements) worth the cost? Let’s explore the pros and cons of these new home loan programs and see if you can — or should — take the plunge into home ownership.

What to Watch Out For

If the housing market declines, borrowers with low down payment mortgages are at higher risk of owing more on their mortgage than their property is worth. Minimal upfront equity also means higher risk of default, prompting reasonable fears of a second housing crisis.

Unlike many of the pre-crises mortgages however, these new programs from Fannie Mae and Freddie Mac come with multiple conditions.

Borrowers must:
o Buy Private Mortgage Insurance (PMI).
o Have a credit score of at least 620.
o Provide documentation of income, assets, and job status.
o Receive home ownership counseling.

Fannie Mae and Freddie Mac aren’t the first lenders to adopt this kind of program. The Federal Housing Administration (FHA) has been issuing mortgages with down payments as low as 3.5 percent for years – and with less stringent guidelines. But FHA loans come with high upfront fees and permanent mortgage insurance.

The Impact of Private Mortgage Insurance

With less than 20 percent down though, even borrowers with good credit are responsible for paying Private Mortgage Insurance (PMI). Though PMI payments can be canceled once homeowners gain 20 percent equity in their homes- building from 3 to twenty percent can take years of pricey PMI payments.

PMI was designed to cover the risk lenders take in issuing small down payment mortgages, as smaller down payments are associated with higher chances of default. Rather than lenders shouldering that burden though, it’s consumers that get stuck paying the “risk premium.” PMI payments are tacked onto monthly mortgage minimums until the 20 percent threshold is reached. Unlike mortgage payments, PMI does nothing to help grow or build equity – once the money is gone, it’s gone.

Promoting Affordability

Proponents of 97 percent LTV programs argue that the opportunity to purchase a home with a three percent down payment promotes affordability. Ninety seven percent LTV mortgage issuers also contend that fees and rate increases on low down payment mortgages are minimal compared to value added from earlier home buying. Their argument is that the time it takes to save up for a larger down payment could mean higher home prices and a harder time qualifying in the future. While that certainly is a possibility, the argument operates on a dangerous (and recently proven false) assumption- that home values will always rise.

Short Vs. Long-Term

Concerns and arguments over affordability ultimately come down to a short-term vs. long-term perspective.

While 20 percent down payment mortgages are more cost prohibitive to begin, they are less expensive over the life of the loan as they require no Private Mortgage Insurance payments and may come with more favorable interest rates. Ninety-seven percent LTV mortgages on the other hand, provide increased affordability up front, but prove more expensive over the life of the loan due to higher rates and PMI costs.

Consumers should also consider the opportunity cost of low down payment programs. Money spent on interest and insurance doesn’t build equity or wealth. Rather than jumping into homeownership prior to saving up for a full twenty percent down payment and being saddled with the extra costs, consumers can use otherwise “wasted wealth” to invest- leveraging their money more effectively.

For instance, a couple owning a $250,000 home takes the $208 per month they’re spending on PMI and invests it in a fund with an annual compounded rate of return of 8 percent – in 10 years, that money would grow to $37,707. That’s a high opportunity cost.

A Good Deal?

Less money down doesn’t necessarily translate to a good deal. The upfront ease of attaining a low down payment mortgage could wind up costing consumers far more than it’s worth over the long haul.

The recent history of underwater mortgages should not be quickly forgotten. If consumers can’t save up enough to afford a twenty percent down payment or even ten percent, they probably shouldn’t be taking on the significantly higher lifetime cost of these new home loan programs, however cost-effective they are in the short-term.

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