Question

5. 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

Answer 1

1) Very low downpayments imply that there is very little downside for the borrower on defaulting and the bank possessing the house. Thus there is little incentive for the borrower to pay back to the bank and keep his house as his intial stake is very low in the property.

2) With a 20% downpayment, the house owner feels that if he defaults, then his contribution would be wiped out and thus he would work hard to pay back the mortgage on time. Thus 20% is an acceptable level of downpayment that disincentivises defaults.

3) Has there been a higher value of downpayment in 2008, then so many defaults in mortgages would not have happened. and so the 2008 crisis which was started by a downfall in housing price and consequent rise in defaults would have been prevented.