Would you take the bet? I wouldn’t suggest it as we’ve seen this party before. As I’ve mentioned before the number one determinant of a default is leverage. This is obvious, yet our wonderful federal government doesn’t seem to grasp this concept. For a government sponsored loan like an FHA loan you can borrow up to 95%. What happens if you don’t have the 5% down. You are in luck! You can now get 100% financing! Sound Familiar? This is has the markings of another real estate crisis. The solution to the impending crisis is easy.
An American Indian tribe has created a down payment assistance program which enables borrowers to receive a 100% loan with the FHA. Basically, a fund was created, Chenoa Fund, that will lend the borrower the 5-10% down payment required. The borrower brings nothing to the table, borrowing 90% from the FHA and 10% from Chenoa fund. This sounds quite familiar!
In the 2000s, Ferguson ran a similar program, which allowed home sellers to in essence fund buyers’ down payments. Congress later banned such operations, which ended up costing the FHA’s insurance fund $17 billion when borrowers got in trouble. “When things went south in the last downturn, those folks were riskier—they defaulted at much higher rates,” says Joe Gyourko, a real estate and finance professor at the University of Pennsylvania’s Wharton School. “Ultimately, we forget and go back and make the same errors.” (Bloomberg)
Buyers underwater immediately
The biggest problem with 100% loans is that the buyers are underwater immediately. If someone bought a house and needed to sell 6 months later, after factoring in a 5% commission and closing costs, the seller would have to bring money to the table to sell the house. Obviously, this would not be feasible as the seller was unable to bring funds for the purchase; the seller is “stuck” in the house with no equity.
No rainy day fund
Buyers with high leverage have no “rainy day” fund. As we all know, things happen that can have a cascading impact. For example, let’s say after they buy the house, the owners work vehicle breaks down and needs a two-thousand-dollar repair. The owner does not have the funds to fix it and therefore their income is impacted which impacts their ability to pay the mortgage.
Hiccup amplifies risk
We saw in the last cycle that economic “hiccups” amplify the risk. Borrowers living on the edge with no savings are most susceptible to being negatively impacted by changing economic conditions. When economic cycles occur, workers are impacted by less hours, less pay, possible job relocations, and various other changes. Without a rainy day fund this risk is amplified for high leverage borrowers.
Along with loss of income, during an economic cycle prices fall. We saw this in the last cycle and it will occur again. AS prices fall, borrowers are underwater immediately and face a decision to pay a mortgage on a house that is worth less than the one next door or simply walk away as they haven’t really “lost” any of their own money as the borrowed 100%.
What is the solution?
The government should eliminate any down payment assistance programs that further leverage the borrower. The only way to assist borrowers would be through some sort of a grant that the borrowers do not have to pay back if they stay in the house for 5 or 10 years. This would not only reduce the borrower’s payment, but also provide instant equity to the borrowers. With equity, borrowers are considerably less likely to default.
Steps need to be taken today to eliminate programs that provide 100% financing and leave taxpayers on the hook. The last recession costs taxpayers over 17 billion. Wouldn’t that money be much better spent on a grant program that would mitigate future losses and another real estate crisis?
Resources/Additional Reading
I need your help!
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in the Colorado Real Estate Journal, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
Fairview is a hard money lender specializing in private money loans / non-bank real estate loans in Georgia, Colorado, Illinois, and Florida. They are recognized in the industry as the leader in hard money lending with no upfront fees or any other games. Learn more about Hard Money Lending through our free Hard Money Guide. To get started on a loan all they need is their simple one page application (no upfront fees or other games).