Why You Can’t Afford a 3% Down Payment Mortgage

Stefanie O'Connell Friday, March 20, 2015

The closer I get to thirty, the more I fantasize of the trappings associated with the stereotypical “American Dream”- the husband, the 2.6 children, and the house with the white picket fence. My late 20s wanderlust is still alive and well, but the idea of putting my roots down and calling my own place home is becoming increasingly attractive. I find myself perusing the New York Times real estate section or Zillow at least once a week, identifying the features of my dream home.
My financial reality however, dictates that my dream home will in fact remain a dream for quite some time – not just my dream home, any home. The cost of a down payment is prohibitively expensive- even modest living quarters go for around half a million in my neighborhoods of choice. With a twenty percent down payment, that’s an upfront investment of 100k- not to mention taxes, closing costs, etc. Even if I could afford the mortgage and monthly maintenance fees, the down payment remains a major barrier to home ownership.
Lenders Fannie May and Freddie Mac have recognized this barrier for low-income and first-time homebuyers and have put in place programs to open up lending by reducing the upfront investment required. The mortgage giants have announced that they will back mortgages with down payments as little as three percent of the home’s price. The programs are for fixed-rate loans for first-time homebuyers and those looking to refinance their primary residence- they come with several conditions.

• Borrowers must buy Private Mortgage Insurance.
• Borrowers must have a credit score of at least 620.
• Borrowers must provide documentation of income, assets, and job status.
• Borrowers must receive home ownership counseling.

Fannie Mae and Freddie Mac aren’t the first lenders to adopt this kind of program. The Federal Housing Administration also issues mortgages with down payments as low as 3.5 percent. At that rate, my hypothetical 500k home down payment goes from a prohibitive 100k to a totally reasonable 17.5k.
While all of this sounds like great news for buyers like myself who’d like to own but don’t have the cash for a large up front investment, there are reason to be wary.

• Small down payments can leave borrowers at more risk of owing more on their mortgage than the property is worth should home values in the market decline. Sound familiar?

• Borrowers will likely incur higher costs over the life of the loan from higher interest rates and mortgage insurance.

A 3% down payment mortgage (or any other low down payment mortgage) is more likely to default than one with a large down payment- that means more risk for lenders and translates into higher costs for borrowers. The Private Mortgage Insurance (PMI) that comes with these low down payment loans protects lenders when borrowers default on their mortgages- but it’s not the lenders who pay for it, it’s you, the borrower.
Mortgage insurance premiums typically range from $250 to $1,200 per year. The programs from Fannie Mae and Freddie Mac require you to continue paying that premium until you gain 20 percent equity in your home – with a three percent down payment, that could take years.
To put it into perspective, if a couple owning a $250,000 home were to take the $208 per month they were spending on PMI and invest it in a mutual fund that earned an 8 percent annual compounded rate of return, that money would grow to $37,707 in 10 years. Money that goes to PMI doesn’t grow or help build equity – once it’s gone it’s gone.
You can avoid paying PMI by not taking on low down payment loans. Yes, there’s a larger upfront investment required, but over the life of the loan, the total costs are far fewer with a large initial deposit. It’s not just PMI either. Putting down such a small amount usually means a paying a higher interest rate in general. Over the course of a 15- or 30-year mortgage, that can mean paying thousands of additional dollars.
Even fractions of percentage point tacked onto an interest rate can raise overall costs significantly. For instance, a $200,000 30-year fixed-rate mortgage with an interest rate of 7 percent would cost you $1,330.60 per month – $279,017.80 in interest over the life of the loan. At 7.5 percent interest, the monthly payment on that same loan would be $1,398.43, coming to a total of $303,434.45 paid in interest over the life of the loan. That’s an extra $25,000 for half a percentage point. Putting more down gives you more leverage to negotiate a better interest rate with lenders- don’t discount the difference of a fraction of a percentage point.
Less money down doesn’t mean you’re getting a good deal. It might mean an easier time coming up with a down payment, but with PMI and higher interest, that temporary ease can cost you far more than it’s worth over the long haul, not to mention the increased risk of getting stuck with an underwater mortgage.
While I can certainly afford a 3% down payment mortgage today, I can’t afford the higher cost implications over the next thirty years. Instead I’ll continue paying my cost effective rent while I save up the twenty percent down payment for my “American Dream” home.