Conventional wisdom (and the average member of Congress) says that the key to preventing future foreclosure epidemics is making sure that borrowers have more “skin in the game.” That means requiring a higher down payment to buy a home.
There are a few things wrong with this conclusion.
1. According to a 2010 Federal Reserve study of borrowers in Arizona, California, Florida, and Nevada who financed their home purchases with 100 percent loans, 80 percent of defaulters experienced an income shock in addition to negative equity. Of the 20 percent who defaulted solely because of negative equity, the folks we call strategic defaulters, the majority of them didn’t give their homes back until they were more than 50 percent underwater! In fact, the median strategic default decision didn’t take place until the homeowner had 62 percent negative equity. Even borrowers with 100 percent mortgages — zero skin in the game — weren’t likely to strategically default until they were extremely underwater. If homes are going 50+ percent underwater, requiring an extra 5 percent down won’t do much to help.
2. VA home loans boast mortgage lending’s lowest foreclosure rate today even though about 90 percent of borrowers purchase their homes with zero down. The foreclosure rate for VA mortgages for Q4 2012 was just 2.08 percent, while the the rate for prime loans was 2.10 percent and for FHA mortgages it was 3.85 percent. The VA’s success has been attributed to the fact that military families consider strategic default on a VA-backed mortgage to be un-American. In addition, the VA requires its loan servicers and lenders to work with military families, offering mortgage modification, forbearance and other foreclosure mitigation.
3. For decades, the USDA ‘s Rural Housing programs with 100% financing have experienced a default rate of about 1.7%. This program’s success may be the result of the extreme difficulty borrowers would face if they were to default. USDA borrowers who default may be subject to severe collection tactics, courtesy of the US Department of Treasury:
- Their tax refunds may be seized.
- Up to 15 percent of Social Security payments and 15 percent of a borrower’s take-home pay are also up for grabs.
- The department may tack on up to 28 percent more to cover collection costs.
In this case, it’s the difficulty of strategic default that keeps borrowers honest.
Preventing a rerun of the mortgage crisis does not depend on keeping people without piles of cash out of the housing market. It depends on making sure applicants are well-qualified, with loans going to those with stable incomes who have demonstrated both the ability and willingness to pay their obligations on time. In addition, making it more difficult and punitive to walk away from underwater mortgages would take strategic default off the table for most people.
You shouldn’t have to be rich to finance a home, but you should have good character.
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