Question

In: Finance

There have been times where mortgage institutions have allowed borrowers to put very little down. Sometimes...

There have been times where mortgage institutions have allowed borrowers to put very little down. Sometimes as low as 1%. What are some foreseeable outcomes of very low down payments? Why does this suggest that historically, 20% down payments are the norm? Why do many people believe the financial crisis of 2008 was because of too many low down payment houses?

House Value – Year 1 (Purchase)

Money Put down by purchaser (Down Payment)

Bank Loan (Mortgage)

Tax Rate

Interest Paid to Bank (10% loan – @ tax bracket)

House Value at point of sale (after 3 years)

Net Return on house investment (increase in house value – payments to bank)

Return on Equity = Net Return / Money put down

$100,000

$100,000

50%

$120,000

$100,000

$50,000

50%

$120,000

$100,000

$20,000

50%

$120,000

$100,000

$1,000

50%

$120,000

Please fill in the blanks in the table.

Solutions

Expert Solution

Some forseeable outcomes of very low down payments would be:

  • low down payment require will encourage borrowers to take more loan for their houses whether or not they have the ability to repay it back. It is just like allowing eveyone to own a house with a small token amount without analysing the credit risk related to it. They will have no reason to stick to the property if any problem occurs.
  • Low down payment will encourage more credit buyers which will give spiral effect to the whole market and make the whole ice ball rolling.
  • Bank encourage low down payment because this will be a high risk mortgage for them and they get to charge high interest rates from the customer or reposses their properties.

Why 20% down payment is the norm

Following reasons can be attributed to 20% being the norm:

  • Down payment is generally seen as protective payment and default compensation by lenders. This ensures trust from lender. This helps reduce the risk for any mortgage.
  • For the buyers also, this helps to reduce burden of interest and equal monthly installment to be paid later on, as less principal amount is due to be paid. After paying significant amount of money upfront, the borrower also gets a upper edge to negotiate the terms and interest rates as it has helped to make the mortgage a lot less riskier.

2008 Financial crisis

It will not be wrong if we say that 2008 Housing market fall down was caused by low down payments. As banks were selling all their loans to customers at low down payments and high interest rates however the same was done without any prior background check or after checking borrower's ability to repay the loans. It all created a fake spiral which lead to 2008 financial crisis.

Table


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