FHA Loans: Return to 0% Down

The days of home buying with little or no money down may be back—this time thanks to Uncle Sam.

Blamed for contributing to the housing bubble, zero-down-payment loans largely vanished when the market crashed and Congress blocked seller financing for government-backed loans. Now the federal government will be forking over cash at closing.

Buyers who haven't owned a home for three years or longer are eligible for an $8,000 tax credit, thanks to a provision in this winter's stimulus package. Now, under a little-noticed program announced May 29, the Federal Housing Administration will steer the funds to cover closing costs directly—in some cases even offsetting the 3.5% minimum down payment FHA loans require. That's enough to cover most or all of the down payment and fees for homes up to the U.S. median price, now about $169,000.

Officials hope "monetizing" the tax credit will help revive the housing market, because meeting closing costs is one of the biggest hurdles for new home buyers. The National Association of Home Builders predicts it will add 40,000 to the 160,000 sales originally expected to be spurred by the tax credit. Supporters say the move avoids the worst effects of seller financing, in that the credit is essentially the buyer's money, and government assistance doesn't give sellers a perverse incentive to inflate prices in an unsustainable manner.

Does Down Payment Aid Boost Defaults?

But while seller financing is riskiest, buyers who get down payment help have higher default rates, whether the money comes from government or other sources. That was shown in research by Austin Kelly—who oversees risk modeling at Fannie Mae and Freddie Mac for the FHA—published late last year in the Journal of Housing Research. FHA data on foreclosures show the same pattern.

The new program lets home buyers apply the tax-credit advance against the FHA's 3.5% down payment requirement only if the loan is handled through a state housing-finance agency; otherwise the tax advance may only be used to cover closing costs, to increase the down payment, or to buy down the mortgage's interest rate. The FHA already allows down payment assistance from family, employers, and governmental agencies, but generally bars it from sellers, mortgage writers, or others who would benefit financially from the transaction.

Ultimately, critics complain that the new program transforms a tax credit meant to reward sidelined buyers for taking the plunge into a subsidy that could goose sales to those who otherwise couldn't buy a home—and have little at stake if it doesn't work out. "Didn't we just have this big housing bust where people bought houses they can't afford?" says Peter Schiff, president of brokerage firm Euro Pacific Capital and an economic adviser to Representative Ron Paul's (R-Tex.) long-shot 2008 Presidential campaign. "We don't want people buying houses without using their own money."

Supporters counter that the benefits to the housing market and economy outweigh the risk to taxpayers. David Crowe, chief economist for the homebuilder's group, says most buyers will stay in their homes if possible, even without much money at risk. "As long as they can make the payment they'll stay, even if they're under water," he says. Still, he acknowledges that the new program "increases their likelihood of default, there's no question."

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