Fannie Mae and Freddie Mac recently announced plans to accept down payments as low as 3%. The programs are nearly identical, with a few exceptions.
Freddie Mac will accept 3% down payments under their new Home Possible Advantage program for mortgages closing on or after March 23, 2015.
To qualify for a Freddie Mac mortgage with a 3% down payment, a homebuyer needs to:
- use the mortgage to fund the purchase or a no-cash refinance;
- occupy the property securing the mortgage as their primary residence;
- own no interest in any other residential property as of the note date, eliminating homeowners who want to finance the purchase of a home before they have sold their current home;
- have an annual income no greater than the area’s median income (different rules apply for high cost or underserved areas — a look-up tool for area income limits is available here);
- purchase or refinance a one-unit, non-manufactured home (condos are allowed); and
- have a maximum back-end debt-to-income (DTI) ratio of 43% (there is no front-end DTI limit).
First-time homebuyers must first fulfill education requirements, which can be met through:
- an internet-based homeownership education program developed by a mortgage default insurance company; or
- a homeownership education program which meets the standards set by the National Industry for Homeownership Education and Counseling
Further, the mortgage needs to be:
- a first trust deed lien;
- conventional (no government-insured mortgages);
- fully amortizing;
- a fixed rate loan with a term no longer than 30 years; and
- within the maximum loan-to-value (LTV) ratio of 97%.
The mortgage insurance coverage level on a mortgage with a down payment greater or equal to 3% and less than 5% is 18%. These mortgages are not eligible for custom or reduced mortgage insurance.
Fannie Mae now also allows down payments as low as 3%. This is offered through either:
- their My Community Mortgage (MCM) program for first-time homebuyers, for those who meet Freddie Mac’s annual income and DTI ratio limitations; or
- standard purchase transactions for all other first-time homebuyers who exceed median incomes.
Freddie Mac and Fannie Mae’s rules conform on most points. However, Fannie Mae’s program differs in that:
- homebuyers taking out non-MCM mortgages do not have to fulfill education requirements;
- homebuyers may not have owned a residence during the last three years; and
- limited cash-out refinances are allowed for non-MCM mortgages.
Fannie Mae and Freddie Mac will allow homebuyers taking out these low down payment mortgages to use down payment gifts, as long as the property is a single unit. This may bring out the builders, as prior to 2008 it was common for builders to indirectly gift the full required down payment on Federal Housing Administration (FHA) and later conventional mortgages (through help of a third party “facilitator”). These Nehemiah loans, as they were sometimes structured, were all the result of 1990s deregulation.
However, Fannie Mae qualifies 2-4 unit and manufactured homes as long as homebuyers make a minimum 3% contribution which cannot be covered by gift funds.
Fannie and Freddie claim these mortgages will cost the homebuyer slightly less than FHA-insured mortgages. This is due to the slightly lesser cost of private mortgage insurance (PMI) compared to the FHA’s mortgage insurance premiums (MIPs).
A good idea?
If the homebuyer and the property meet the program qualifications, the homebuyer may qualify to put down as little as 3%. However, just because Fannie and Freddie are willing to purchase this low down payment type of mortgage doesn’t mean lenders will be willing to originate them.
Prior to this change, Fannie and Freddie required a minimum 5% down payment mortgage. This minimum contribution was already low, in light of annual home price fluctuations, especially during this volatile recovery.
With such low down payments, new homebuyers have less skin in the game. Thus, if home prices dropped, say, more than 3% in a year (actually most likely in the first few months of 2015), homebuyers would suddenly have a negative equity asset on their hands. This negative equity condition has recently proven to be an incentive to default on mortgage payments.
Lenders tend to be more conservative than Fannie and Freddie, citing the fear of buy backs when underwriting errors exist and the homebuyer defaults. This fear is particularly warranted when programs — such as these — introduce a greater risk of default and impose additional underwriting requirements. Therefore, expect lenders to be very cautious when it comes to offering 3% down payment mortgages of the conventional type.
Remember, lenders still receive 0.25% risk-free interest on bank reserves from the Federal Reserve (the Fed). Thus, they have less impetus to lend, evidenced by the exponential increase in excess bank reserves (excess reserves at the Fed have risen 1,300 times their amount in 2008 as of October 2014).
If lenders do decide to take on the additional risk, these low down payment programs might open the door to homeownership for many ready and willing first-time homebuyers years before they otherwise would have been able to buy.
If these programs are a success, they’ll certainly help our failing housing recovery end more quickly. We’ll see what lenders choose to do with them; once again, the ball is in their court.