The FHA Wants to Make Zero-Down Loans. Is This a Good Idea?

Peter Coy

When the FHA was started in the Depression to insure mortgage loans and thus help people of modest means buy homes, it required a minimum downpayment of 20%. That hefty chunk of equity ensured that people wouldn't walk away from their homes if they ran into trouble. Plus, the ability to raise the downpayment was seen as evidence that the buyer was financially responsible and knew how to save money.

Over the years the downpayment requirement for FHA-insured loans shrank to 3%. It was a thin shell of equity surrounding a big ball of debt.

Now, the FHA has decided that even 3% is too steep a requirement for homebuyers. The FHA has been losing market share to others who require 2%, 1% or zero percent downpayments, including giant loan buyers Fannie Mae and Freddie Mac and many subprime lenders. So the federal agency has asked Congress to repeal the 3% minimum, and it appears that Congress is going along. On July 25, the House of Representatives voted 415-7 in favor of the "Expanding American Homeownership Act," which among other things would repeal the 3% rule. The Senate is expected to pass similar legislation, and the White House has expressed support.

Is this a good thing? Maybe, maybe not. I'm not so worried about lenders getting stiffed. I figure they can take care of themselves. I'm more worried about families that are lured by the no-money-down pitch into buying houses they can't afford. Some will end up killing themselves to keep up with payments. Some others will default and destroy their credit ratings.

I spoke today with Margaret Burns, director of FHA's Office of Single Family Program Development, and her deputy, James Beavers. They don't think default by zero-down borrowers is a big risk. They argue that credit-scoring software can tell them with great accuracy, based on bill-paying history, etc., which people can be trusted with loans.

Lenders who think downpayments aren't necessary regard them as relics of an era when lenders didn't know very much about their customers and couldn't trust them. The FHA's Burns says that today, most people who get zero-down loans from non-FHA lenders are financially responsible and do have cash on hand, but simply choose to use their cash for things other than a downpayment. She says the FHA is losing business to the competition by insisting on a downpayment that no longer serves an important economic function. And Beavers says the FHA's loans, even if they get rid of the 3% downpayment, are safe for borrowers because they don't have easily abused features like interest-only or negative amortization. "For us," says Burns, "the 3% is a big barrier to homeownership for people who should be able to benefit from FHA-insured loans."

Mortgage Bankers Assn. senior economist Mike Fratantoni had a similar opinion. Yes, he said, there's a danger to fragile neighborhoods if people default on zero-down loans. But that's more than offset in his opinion by the benefits to society from giving families a stake in society through homeownership.

Maybe the FHA and the MBA are correct and there's nothing to worry about here. To me, though, it seems like the FHA is simply joining a race to the bottom that was already in progress, with lending standards getting lower and lower in the name of competition. Sure, zero-down loans are fine for some buyers. And sure, homeownership can be a great thing. But not all families are financially suited for it. I worry about those who buy houses they shouldn't and then live to regret their choices.

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