Congress's Risky Zero Down Payment Plan Will Undermine FHA'sSoundness and Discourage Self-Reliance

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Congress's Risky Zero Down Payment Plan Will Undermine FHA'sSoundness and Discourage Self-Reliance

July 7, 2004 5 min read
Ronald Utt
Ronald Utt
Visiting Fellow in Welfare Policy

Ronald Utt is the Herbert and Joyce Morgan Senior Research Fellow.

The Zero Down Payment Act of 2004, introduced by Rep. Pat Tiberi (R-OH), would require the Federal Housing Administration (FHA) to offer federally insured mortgage loans to certain eligible households to buy a house without a down payment. Although the bill could lead to a very modest increase in the homeownership rate, it would do so by exposing the FHA-and ultimately taxpayers-to major losses stemming from high default rates, as evidence from similar FHA programs shows. The Congressional Budget Office estimates that the new program would cost the government $618 million from 2006 through 2009.


In addition, the bill would continue the process, begun last year with the enactment of the American Dream Down Payment Act[1], of undermining financial self-reliance among middle class families.


Risky Incentives

The Zero Down Payment Act (H.R. 3755) would require the FHA to allow eligible first-time homebuyers and "displaced homemakers" to buy a house without having to provide a down payment. Under this plan, buyers would be able to borrow more than 100 percent of the purchase price of the house, and the FHA would insure the lender up to the full amount of the loan in the event of borrower default and foreclosure.


These mortgages are risky because of the absence of an owner-provided down payment requiring some personal sacrifice to accumulate. Without a financial stake in the house, subsidized buyers have less incentive to be responsible owners. Such owners see themselves as little different from renters and often act accordingly. Indeed, one financial analyst contends, "A home without equity is just a rental with debt."


Advocates for the bill contend that the absence of the money to provide the required down payment deters many otherwise eligible households from becoming homeowners. Current rules for most FHA loans-and common practice for most conventional lending-require the borrower to provide a down payment of between 3 to 5 percent as an equity cushion against potential loan loss through default. Under FHA's most popular program, the required down payment is three percent of the purchase price. With today's median-priced existing home selling for $183,600, half the homes for sale in America can be purchased with standard FHA financing for a down payment of $5,490 or less.


Although FHA's required down payment is 3 percent of the house's value, borrowers are permitted to finance all their closing costs through the mortgage, including FHA's upfront insurance premium. The consequence of these added costs is that the mortgage amount often exceeds 97 percent of the house's value. Similar cost shifting privileges will be available to borrowers under the Zero Down Payment program, meaning that these FHA loans will be insured for more than 100 percent of the purchase price of the house. As a result, FHA's insurance exposure will exceed the value of the collateral by several thousand dollars on such loans.


Poor Performance and Worse

Evidence, including several reports from the HUD Inspector General, suggests that no-down-payment mortgages have significantly higher default rates than those where borrowers were required to use their own funds for a down payment.


Recent performance shows that all types of FHA mortgages suffer from higher default rates than other mortgage loans. During the first quarter of 2004, conventional mortgages experienced a default rate of 2.25 percent, meaning that payments due on 2.25 percent of these mortgages were past due by 30 days or more. In contrast, FHA mortgages experienced a default rate of 11.66 percent in that same quarter, nearly five times greater. Disturbingly, the default rate on FHA loans also exceeded the default rate of conventional loans rated as "sub-prime," defined as a loan made to a borrower with a below average credit record.


Reflecting a long-term deterioration in FHA loan performance, FHA's most recent default rate of nearly 12 percent compares poorly to the 1998 default rate of 8.5 percent and the 1980 default rate of 6.6 percent. In contrast, over that same period default rates on VA mortgages increased from 5.3 percent to 7.4 percent, while conventional mortgage default rates actually fell slightly, from 3.1 percent in 1980 to 2.25 percent in early 2004. These contrary performance measures suggest that the rising default problem is unique to the FHA, whose underwriting standards were significantly liberalized during the Clinton Administration, and not related to any economy-wide problems that would have affected all borrowers.


As evidence from existing "no down payment" FHA programs reveals, lowering the down payment to zero and insuring mortgages with negative equity will lead to even higher default rates than those typical of traditional FHA programs. In March 2000, the HUD Inspector General reviewed the performance of several special "down payment assistance" programs in which FHA participated in partnership with not-for-profit organizations that provided prospective borrowers with a gift of cash to cover the down payment. The best known of the nonprofit partnerships is the Nehemiah program that operates in four cities.


In its analysis of these programs, the Inspector General reported, "Empirical information developed during the review shows higher default rates for loans involving down payment assistance gifts provided by nonprofit organizations than for other FHA loans." A follow-up report released in September 2002 was even more critical, noting, "The defaults on these 2,261 loans have risen dramatically and, as of February 15, 2001, the default rate increased to 19.39 percent compared to a 9.7 percent default rate for FHA loans without Nehemiah assistance in the same four cities."


Such problems have characterized other HUD no-down-payment mortgage programs in the past, most notably the infamous Section 235 program of the late 1960s. Among the many financial disasters that have befallen HUD over the years, the Section 235 program was one of the worst. Exceptionally high default rates, property abandonment, and costly foreclosures led to budget outlays well in excess of the amount of subsidies provided to buyers. These losses were largely a consequence of foreclosures that amounted to less than the dollar amount of the outstanding mortgages. Since FHA insured these mortgages-as it will do under the new programs-the federal government was ultimately responsible for these losses.


The Section 235 program was such a disaster that it was canceled in the mid-1970s by a bipartisan majority in Congress, and by 1979, 18 percent of the program's mortgages had been foreclosed. The painful lessons of the experience were so enduring that no president or congress since has seriously contemplated the creation of a similar program, until now.



Although homeownership is, without doubt, a valuable policy goal, policies to promote it should create opportunity and encourage individuals to save, not seek handouts. By contrast, the American Dream Down Payment Act and the Zero Down Payment Act reject these approaches and instead foster the kind of dependency that characterized the failed programs of President Lyndon Johnson's Great Society, inlcuding the disastrous Section 235.


For that reason, Congress should be skeptical of such proposals. A better course would be to focus on the growing obstacles to ownership created by the extreme land-use restrictions that are increasingly common in many communities. As studies by a number of researchers reveal, minorities and others with moderate incomes are being excluded from homeownership by these restrictions and regulations.


And at a time when the U.S. homeownership rate is the highest in history and several federal home-loan programs for lower-income and savings-impaired families already exist, the Zero Down Payment Act would be a waste of public resources.


Ronald D. Utt, Ph.D., is Herbert and Joyce Mor­gan Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

[1] See Ronald D. Utt, Ph.D., "American Dream Downpayment Act: Fiscally Irresponsible and Redundant to Existing Homeownership Programs," Heritage Foundation Webmemo No. 378, December 5, 2003.


Ronald Utt
Ronald Utt

Visiting Fellow in Welfare Policy