The Mortgage Professor: Questions about down payment requirements


Second of 2 parts

Q: Are there any substitutes for a down payment?

A: In principle, any collateral acceptable to the lender could serve as a substitute for a down payment. The only such substitute found in the US is securities, which must be posted as collateral with an investment bank that also makes mortgage loans. Borrowers who do this are betting that the return on the securities will exceed the mortgage rate.

Mortgage insurance and second mortgages can also be viewed as substitutes for a down payment. They do not provide the first mortgage lender with additional collateral, but they shift a major part of the risk of the low-down payment loan to a third party who is paid by the borrower for assuming it. The payment is either a mortgage insurance premium or a relatively high interest rate on a second mortgage.

Q: Is it wise to withdraw funds from a 401K to make a down payment?

A: Withdrawing funds is very unwise, since you would be hit with taxes and penalties, but borrowing against your account might make sense, provided your employer allows it and you have no plans to quit. The cost of borrowing against your 401K is not the loan rate, which you pay to yourself, but the return the money would have earned if left in the account.

The risk is that if you lose your job, or change employers, you must pay back the loan in full within a short period, often 60 days. Otherwise, the loan is treated as a withdrawal and subjected to taxes and penalties. Loans from a 401K cannot be rolled over into a 401K account at a new employer.

Q: Who sets down payment requirements?

A: Since the purpose of down payment requirements is to reduce the potential loss from borrower default, the requirements are stipulated by the entity that assumes the risk of loss. Prior to 1934, the risk was borne by private lenders, who seldom accepted down payments of less than 40 percent. With the creation of the FHA program in 1934, the requirement fell to 20 percent, which was historically unprecedented. Private lenders make the loans but FHA assumes the risk of loss, and borrowers are obliged to pay an insurance premium to cover the losses. FHA is still in the business but today it requires only 3 percent down.

A similar program for veterans of the armed forces, developed after World War 2 and administered by the Veterans Administration, eliminated down payment requirements for veterans altogether. This program is still in force.

On loans purchased by Fannie Mae and Freddie Mac, the down payment requirements are set by those agencies, which also require that the borrower purchase mortgage insurance from a private carrier if the down payment is less than 20 percent. Recently, the agencies reduced their lowest requirement from 5 percent to 3 percent, but not all borrowers are eligible.

Q: Who is and who is not eligible for a 3 percent down payment requirement on loans purchased by the two Federal agencies?

A: You are eligible for 3 percent down if you are purchasing a single-family home as your principal residence using a fixed-rate mortgage. Switch to an adjustable-rate and the requirement jumps to 10 percent. If the house will be your second home, the requirement jumps to 20 percent. If you are buying the house as an investment, it goes to 25 percent. And if the property has 2-4 units instead of 1, the requirement is 35 percent. Many other permutations and combinations can be found on the Fannie Mae web site.

Q: There is never any reason to make a larger down payment than the one required, right?

A: Wrong, making a larger down payment is an investment that yields a rate of return that in some circumstances can be very attractive. The rate of return on the funds used to make a larger down payment is at least as high as the mortgage interest rate, and usually higher. The mortgage interest rate determines the interest savings on the amount you don’t borrow. If you increase your down payment by $10,000 on a 4 percent mortgage, for example, you earn 4 percent on the $10,000 you didn’t borrow. The rate of return is increased by any points or mortgage insurance required on your loan, since you also avoid these payments on the money you don’t borrow. My calculator 12a shows the total rate of return on investment in a larger down payment taking account of all cost reductions.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania.  Comments and questions can be left at


Last modified: September 23, 2015
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