A favorite mortgage myth of mine is some variation of:
You can’t buy a home without a 20 percent downpayment.
Let’s address why this is false, using history as a guide.
It all started 50 years ago when real estate information didn’t move as freely as it does today. There was no email, no internet, and no MLS.
In fact, 1956 was the year in which the first Trans-Atlantic phone cable was laid. Getting “the word out” was a decidedly different experience from today.
In 1956, when a bank stopped receiving interest payments on a mortgage, it took two important steps:
- It took the home under possession via foreclosure
- It did everything in its power to sell the home quickly
Remember, banks don’t like to hold real estate because they are not in the Real Estate business. Banks are in the “Making Money on Deposits” business.
To sell the home quickly, banks often sold homes at a discount to their “true” value. Not coincidentally, that have-to-sell-the-home-quickly discount hovered at 20 percent.
Steep, 20% discounts proved a terrific way for banks to rid their balance sheets of non-performing assets (i.e. homes owned by the bank on which no mortgage interest wasbeing paid).
This is why The 20% Downpayment Myth ever existed at all.
Only, it wasn’t a myth up until 1956, it was the rule. A bank simply wouldn’t lend to a homeowner unless there was an up-front, 20 percent deposit on the home’s value. The 20 percent downpayment was really the bank’s insurance policy in case the homeowner defaulted.
In this sense, the bank was protected in the event of default whereas the homeowner stood to lose not only the house, but also the 20 percent.
This affair was truly one-sided in favor of the bank.
Over time, though, banks recognized that not all homeowners could afford 20 percent downpayments. Especially as home values began to increase. Banks also recognized how profitable mortgage lending could be.
So, in 1956, to help mortgage money reach homeowners who couldn't make 20 percent downstrokes, the Private Mortgage Insurance (PMI) industry was born.
The PMI industry does exactly what its name implies — it provides insurance policies to issuers of mortgage credit. Using PMI, a bank could accept a less-than-20% downpayment, while buying an offsetting insurance policy in the event of default.
PMI benefitted the banks in two way:
- More money could be lent, increasing profits
- The homeowner (and not the bank) paid for the bank’s insurance policy
Using PMI, a homeowner could make a 15 percent downpayment and buy an insurance policy for the remaining 5 percent down. This way, if the homeowner defaults, the bank can still drop the price 20% and walk away relatively unharmed — 15% comes from the (former) homeowner, 5% from the insurance.
By 1971, PMI was available for homeowners with just 5 percent downpayment to put down on a home. PMI was spurring homeownership rates in the United States higher and by Q4 of that year, U.S. homeownership rates reached 64.5% — an all-time high.
Now, somewhere along the way, banks realized that PMI companies were getting rich off their backs. They got creative about assessing risk, therefore.
If the fabled “20 percent” truly represented a higher lending risk for banks, then the banks were within their rights to charge higher interest rates for lending against it.
And that’s what they did.
To circumvent the PMI companies, banks offered own alternatives for less-than-20% downpayments. Banks devised a system in which home loans were split into two parts — one representing the lower relative risk (the 80% loan), and one representing the higher risk of whatever was left.
A 90 percent loan, for example, was split into one loan at 80 percent loan-to-value and another loan at 10 percent loan-to-value. The 10% loan was named a “second mortgage” and this was the birth of the Home Equity Loan and the Home Equity Line of Credit.
The higher rate assigned to second mortgages is typically based on three factors:
- The homeowner’s credit score at the time of closing
- The amount of money borrowed on the second mortgage
- The combined mortgage sizes versus the value of the home (i.e. 90%, 100%)
For banks, second mortgages were a boon to profits because they captured interest income on dollars that homeowners previously used for PMI payment.
And this concludes why the 20% downpayment myth is no longer relevant — there are two work-arounds that were not available in 1956.
- Private Mortgage Insurance
- Second mortgages
Old Wives’ Tales are rarely true and this myth is one of them.