Down Payment Rules Are at Heart of Mortgage Debate

It seemed an easy fix to prevent the excesses of the housing market: make home buyers put more money down.

But as the housing market starts to return and the subprime mess fades from memory, the issue is up for debate.

Lenders and consumer advocates — rarely on the same side of the issue — are now cautioning against down payment requirements. They argue that such restrictions could limit lending, and prevent lower-income borrowers from buying homes. They also contend that the new mortgage rules put in place this year will do enough to limit foreclosures, making down payment requirements somewhat superfluous.

The arguments seem to run contrary to long-standing beliefs about homeownership. For decades, experts have emphasized the need for a sizable down payment — a rule of thumb being 20 percent — on the premise that borrowers with a sizable chunk of equity in a home are less likely to walk away when things get bad.

“If our goal is to prevent foreclosures, I can’t think of anything more effective than requiring a down payment,” said Paul S. Willen, a senior economist and policy adviser at the Federal Reserve Bank of Boston.

The issue may not be so black and white. Regulators want to protect borrowers and promote homeownership. But they also want to encourage lending and insulate the financial system from future shocks.

And the subprime debacle has only distorted the debate, say some analysts. “The problem with this conversation is that it’s like discussing the future of shipbuilding from the deck of the Titanic,” said Roberto G. Quercia, director of the Center for Community Capital at the University of North Carolina at Chapel Hill. “There’s a lack of perspective.”

To underscore his point, Mr. Quercia studied mortgages in a special program for low-income borrowers, typically those with minimal down payments. From 1998 through the end of last year, 5.5 percent of the mortgages ended up in foreclosure, he found. Subprime mortgages made during the last housing boom, regardless of down payment size, had far higher foreclosure rates, roughly 25 percent.

It’s a critical issue for Washington. Currently, taxpayers, through the Federal Housing Administration, backstop most of the low-down-payment mortgages. But the aim is to curb the government’s involvement in mortgages.

As that happens, policy makers are hoping a major part of the mortgage market will come back. Specifically, they need the return of private bond investors, who once bought trillions of dollars’ worth of mortgage-backed bonds with no government backing.

Other than some small bond deals, that market remains dormant. A major reason is that the banks that sell the mortgage-backed bonds are waiting for regulators to complete rules aimed at strengthening this market.

This is where down payments could play a crucial role. The proposed rules require banks to hold a slice of the mortgage-backed bonds they sell to investors. Banks do not like those types of restrictions.

But lenders would not have to keep a piece of the bonds if the underlying loans included features that made them less likely to default. These exempt loans would be called qualified residential mortgages. Regulators effectively proposed that these loans should have a 20 percent down payment.

The proposal prompted widespread objections from consumer advocates, bankers and home builders, who said the plan could shut many borrowers out of the housing market. Banks, they argued, are likely to focus heavily on making qualified residential mortgages. And if those mortgages require high down payments, lenders will be hesitant to make loans with little money down.

Consumer advocates make a nuanced case. They do not deny that down payments reduce the risk of default. But they say defaults can be reduced almost as much by applying other rules that curb lending to certain types of borrowers.

Consider another set of mortgage rules, already put in place this year. These rules emphasize the affordability of the loan. Under them, a borrower’s overall monthly debt payments cannot exceed 43 percent of personal income.

In his study, Professor Quercia of the University of North Carolina found that loans that complied with those rules defaulted at a relatively low rate during the housing bust. About 5.8 percent of them went bad, irrespective of how much the borrower put down.

He then calculated the losses on loans to borrowers in the same group who had down payments of at least 20 percent. The default rate on that smaller group was lower, at 3.9 percent.

But that lower rate came at a cost. More than half of the borrowers in his study group had to be excluded from the second calculation, because they didn’t have down payments of 20 percent or more. This shows how restrictive a down payment rule could be, said Professor Quercia.

Some real estate analysts are skeptical of this approach. They assert that the new mortgage rules, which do not insist on down payments, may be relatively ineffective at preventing high levels of defaults.

The debt-payments-to-income ratio is not a strong predictor of whether a loan will default, said Thomas A. Lawler, a former chief economist of Fannie Mae who founded Lawler Economic and Housing Consulting, a research firm. “It’s not even in the top three,” he said.

Also, Mr. Lawler and others who favor higher down payments argue that Professor Quercia’s analysis underestimates the psychological and practical importance of the down payment. Borrowers who saved up for down payments may have budgeting skills that later help them make their payments, they argue, and borrowers with equity in their homes are less likely to walk away altogether, rather than try to find a solution.

Supporters of a down payment requirement also make a broader argument. They point out that the financial sector overhaul was not just meant to protect borrowers. It was also intended to make banks and financial markets more resilient to shocks like housing busts. In other words, the legislation always envisioned a trade-off between homeownership and the stability of the financial system.

“The key is what is the right balance between some risk and access,” Professor Quercia said. “Just looking at the risks is one-sided.”