I set out recently to write about a new program of down payment (henceforth DP) insurance, but quickly realized that such an article required an extensive preface that clarifies what the DP is and what it is not. The new program is discussed after that.
Definition of Down Payment
To a home buyer, the DP is the sale price less the mortgage loan amount. It is not the same as the buyer's cash outlay, although the two are often confused. They differ by the amount of settlement costs charged to the buyer. For example, if the price is $100,000, settlement costs $5,000 and the buyer has cash of $20,000, the amount available for down payment is only $15,000. That is why many home buyers pay a higher interest rate in exchange for a lender rebate that will cover some or all of the settlement costs.
The DP is also not the same as the owner's equity, except on the day of the purchase. Owner equity is what the owner could net from selling the property. Where the down payment is a one-time measure as of the purchase date, owner equity changes month by month. It will rise above the down payment as the mortgage loan balance is paid down, and as the market value of the house rises, due either to property improvements or to market changes. Of course, owner equity can also decline if house prices fall, as many owners discovered during the years 2007-2009.
Appraised Value Versus Sale Price
One of the questions I get with some frequency is whether, in the case where the appraised value is higher than the sale price, the difference can be counted as part of the down payment? The answer is "no", from the lender's perspective, the property value used in determining the down payment is the sale price or appraised value, whichever is lower. The only exception to this is when the seller provides a gift of equity to the buyer, who is almost always a family member. In this case, the lender recognizes that the house is being priced below market and will accept the appraisal as the value. Most lenders in such cases will require two appraisals, and they will take the lower of the two. (For more info, read my article Avoiding Taxes on a Gift of Equity.)
Land as the Down Payment
Another common question is whether land purchased as part of a plan to construct a new home can be used as down payment? The answer is "yes", but how the land is valued for that purpose depends on how long it has been held. If the owner has held the land for awhile, the lender will appraise the completed house on the lot, and the difference between the appraisal and the cost of construction will be viewed as the down payment.
For example, if the builder charges $160,000 for the house and the appraisal comes in at $200,000, the land is assumed to be worth $40,000. A loan of $160,000 in this case would have a down payment of 20%.
If the land was purchased recently, however, the lender will not value it for more than its purchase price. If the price was only $30,000, for example, the lender will value it at $30,000, and the down payment will only be 15.8%.
Down Payment and LTV
While home buyers tend to focus on the DP, underwriting and mortgage insurance requirements are defined in terms of the ratio of loan amount to property value, or LTV, where property value is always the lower of sale price and appraised value. One measure is easily converted into the other using the formula DP = 100 - LTV. Home buyers can avoid having to purchase mortgage insurance, for example, if the LTV is no more than 80, meaning that the DP is no less than 20. Using LTV avoids possible confusion regarding what is included in the DP, including the confusion regarding settlement costs noted above.
Down Payment and Mortgage Insurance
From the borrower's perspective, a larger down payment means a lower mortgage insurance premium. For example, a home purchaser with a good credit score who puts 3% down on a conventional loan (LTV is 97) will pay a monthly mortgage insurance premium about twice as large as the premium on an otherwise identical loan with 5% down, and 4 times as large as the premium on an otherwise identical 15% loan. With 20% down (LTV equals 80), no mortgage insurance is required.
House purchasers who need mortgage insurance to buy their first house usually aim to accumulate sufficient equity in that house that when they upgrade to their next house, they won't need mortgage insurance. Down payment insurance is an interesting new tool designed to facilitate that process,
Down Payment Insurance
Investment in a home is often the largest investment a consumer will ever make, so any measures to reduce the risk deserve careful attention. The big risk is that a major house price decline will wipe out the owners' equity, leaving them owing more than their house is worth. That happened just a few years ago, and millions of homeowners are still under water.
I decided a long time ago that the best way to prevent a recurrence of that episode was to offer home buyers property value insurance, and I spent some time advising a well-connected group of entrepreneurs on a program that would do that. After several years of effort, however, the program was scrapped. Various legal and operating barriers turned out to be just too formidable.
Recently, however, I came across a new program called +Plus offered by the Dallas-based firm ValueInsured with which I have no connection. The +Plus program offers to insure the down payment of homebuyers when they sell their homes after 2 but before 7 years from the date of purchase. That won't help homeowners who are still under water, but it is designed to protect new homeowners who purchase the insurance when they purchase their home.
Down payment insurance is a far cry from property value insurance, but down payment insurance is available while property value insurance isn't. Some protection is better than none, and home buyers will have to decide whether the limited protection is worth the price.
The following are the major limitations on the insurance coverage:
Limited Calendar Window: As noted, to collect the insurance the owner has to sell the home within the 2 to 7-year window. The program seems to be aimed at those buying their first home who view it as a "starter," and expect to upgrade in time.
20% Down Payment Is Maximum Loss: Coverage is limited to the down payment which cannot exceed 20% of the purchase price. If you put down 25%, the additional 5% is not covered.
Difference Between Purchase Price and Sale Price is the Maximum Loss: This means that property improvements are not covered: For example, the purchase price is $100,000, down payment is $20,000, the owner invests $5,000 in improvements, and the house is sold for $85,000. The insurance coverage in this case is the purchase price reduction of $15,000 rather than the down payment of $20,000.
Purchase Price Times the Percent Reduction in the House Price Index of the State Is the Maximum Loss: If in the case of a house purchased for $100,000 with 20% down the price index for the state declined by only 10%, the insurance coverage would fall to $10,000. This means that coverage is limited to price declines that are widespread. A price decline that is limited to a city isn't covered unless it is the major city in the state. Price declines that arise from neighborhood or block deterioration would not be reflected in state price indices, and are therefore not covered.
Premiums vary by state, sale price and down payment. On a $200,000 home with 10% down in an average state, the premium would be about $840. That one-time premium is 4.2% of the maximum possible claim of $20,000,
Home buyers have to decide whether the protection is worth the premium charged. If they have to pay in cash at the closing table, my guess is that few will. If lenders package the insurance with a lender rebate that covers all or most of the cost combined with a rate increase large enough to offset the rebate, the prospects are better.
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