Down payments in a mortgage meltdown

A 20% down payment on your next home always has been preferred -- but now it’s expected in today’s market. In recent years, lenders promoted 5%, 3%, and even zero-down mortgage programs, but now they’re tightening the requirements, offering fewer programs and demanding more money up front.

Lenders were previously willing to accept such low down payments -- from people who otherwise wouldn’t be able to afford a house -- because they were unloading the risk of those loans to someone else. The Federal National Mortgage Association (known as Fannie Mae) bought these loans from lenders, bundled them into securities and sold them to investors.

What went wrong?

When house prices fell, too many borrowers owed more on their homes than they were worth. This meant:

Subsequently, it is now harder on first-time home buyers and people seeking to refinance. It also has affected a range of financial transactions, from business borrowing to student loans.

Some mortgage insurers – who back lenders in case of foreclosures -- have marked certain cities on a so-called “watch list” of poor performing real estate markets. Home buyers in those areas may encounter stricter lending standards for down payments. Mortgage lenders across the country are demanding higher credit scores and mortgage insurance, reducing the amount they are willing to lend, or charging higher interest rates commensurate with the heightened fear of default.

Truth about lower/ higher down payments

Although no one prefers to put more money down on their home, the lower your down payment, the less equity you’ll start out with in your new home. Most borrowers who put down less than 20% will have to pay for private mortgage insurance (PMI) to protect the lender in case the borrower no longer can meet the monthly payments. The PMI easily can exceed $1,000 a year if you put 5% or less down on a $200,000 home. If you’re still set on a lower down payment, the good news is that many cities offer programs providing below-market loans with little or no mortgage down payment. Most of those loans are limited to urban areas that have low to moderate income.

If you want a more expensive home, yet still have trouble coming up with a 20% down payment, you can use two loans: one for 80% of the purchase price and a “piggy-back” loan for the remaining 20%. The downside is that remaining 20% often will come at a significantly higher interest rate.

Indeed, there are lenders still offering low-down payment programs, ranging from zero to 5% down, but the credit scores required to get those loans are much higher. Whereas a 625 credit score was considered “good” a few years ago, today it’s above 675.

Consider a FHA loan

A Federal Housing Authority (FHA) loan is actually more like insurance than it is a loan. You’ll still receive your loan through banks, credit unions and private lending organizations. However, a loan secured with FHA approval means that your mortgage is insured to the lender in case you default.

Usually only a 3% down payment is required to secure an FHA loan. And unlike more traditional loans, the money for down payments can be a gift to you from outside sources, like a relative. In addition, the credit qualifications for an FHA loan are often less stringent than with conventional loans.

More help may be on the way

The House Ways and Means Committee approved a bill in April 2008 to give tax breaks to first-time home-buyers and investors in low-income rental housing. Under the housing tax plan, first-time home buyers would receive a 10% credit, up to $7,500 on the purchase of a new home. Lower earners — those making $70,000 individually or $140,000 for a couple — receive smaller credits. It’s an interest-free loan from the government to help you make down payments; you would have to pay back the credit over 15 years.

If you are looking to take advantage of the lowered home prices, then opting for a FHA loan can help you obtain a great mortgage with lowered interest rates. In addition, taking steps to continue to improve your credit will help you obtain the best mortgage for the home of your dreams.