The Wall Street Journal has a story this morning about the return to historical norms when it comes to down payment requirements by lenders in the residential real estate market. The reporter, S. Mitra Kalita, did a very nice job explaining the mechanics of the lending market and hit upon a very important point:
The median down payment hovered around 20% in the late 1990s and began to creep downward in 2001 in the nine cities Zillow analyzed: Chicago; Stockton, Calif.; Las Vegas; Los Angeles; Miami-Fort Lauderdale; Phoenix; San Diego; San Francisco; and Tampa, Fla.
It fell as low as 4% in the fourth quarter of 2006, and in some markets came close to zero. Economists say it is no coincidence that those are the same markets sinking deeper underwater, meaning the value of homes is less than the debt owed on them.
It amazes me that there is a significant portion of the population that doesn’t adequately understand the mechanics of leverage. If you buy a $500,000 house and put 4% down, that is only $20,000. The annual interest expense on the property is going to exceed that (at an APY of 5%, you’re looking at $24,000) plus you’ll have at least a few thousand dollars on top of that in private mortgage insurance. Then you have the expense of insuring, maintaining, heating, and cooling a larger space. If you can’t handle a $100,000 down payment on a property of that size, you won’t be able to afford the upkeep. Furthermore, it would take a relatively tiny drop in housing prices for you to experience a 100% loss of equity in addition to the net interest expense and other costs that your pocketbook has incurred.
The risk of leverage like that is stupid enough, but at least someone who is going for broke and putting it all on the roulette wheel in a business venture or speculation has the chance at payoff. Instead, there seems to be a significant portion of Americans who want to take on the down side of leverage not for a chance at a higher net worth, but to live beyond their means, in a house they cannot afford, to impress people about whom they do not care.
Don’t get me wrong. There are limited circumstances under which no-money-down can be intelligently utilized for financial advantage. An intelligent business man with little to no debt, plenty of cash, and a high income might expand his holdings by such a loan if he believed interest rates were unsustainably low. In effect, he would be shorting the United States dollar. Such a situation would only apply to about 1% of individuals. Of course, everyone is going to think they are it.
I, myself, did this with the Federal student loans offered by the United States government during my undergraduate years at college. I was able to borrow at a fixed-rate of 2.75% with a 20 to 30 year repayment schedule. If inflation returned to 3% to 4%, my cost of borrowing would be negative, meaning I’d be paid to borrow cash and invest it. It would be insane for me not to take money on those terms unless I believed deflation was imminent (after all, who would have thought life insurance companies would be getting creamed in Japan by offering 2% or 3% rates of return to their policyholders?).
Real estate agents are saying such a move will kill the housing recovery. While it is true that, in the short-term (a few years), it might put a damper on things, we need to begin removing leverage from our economic system. After all, the last time I checked, the average down payment for a home in China was in the 40% to 50% range due to the cultural aversion to debt. A housing recovery in a nation like that is going to be far easier because homeowners have a much larger incentive to stay and heal the financial damage with time, rather than defaulting and walking away, amplifying systematic risk.