If you're a first time home buyer, a low down payment mortgage might sound like a perfect solution for your problem.
However, before you sign your name on that dotted line, you better understand the risks that come with this type of mortgage.
In fact, we don't have to go too far back into the past to see how horrible these mortgages can be.
Low Down Payment Mortgage 2007-2008
If you're old enough to consider purchasing a home, then I'm assuming you remember the 2007-2008 housing crash.
The people most affected by the crash were first time home buyers with... you guessed it... low down payment mortgages. Why you might ask? Let me explain.
Debt vs. Equity
First, we need to understand the difference between these two concepts.
Debt is borrowed money that is backed by an asset. This means when you take out a loan on a house, if you don't make your payments, the bank will take your house (the asset) to ensure that they get all their money back.
Equity, on the other hand, is what I would call money given. When you invest in stocks, you give money to a company for them to expand or grow their business. If they fail to do this, your money disappears. If they accomplish their goals, then your money grows as well.
The Housing Crash
Prior to the housing bubble bursting, Forbes states that the median selling price for a home in the United States was $200,000. By the time prices reached the bottom, the median home price fell 29%.
Here is where the debt and equity part comes in. The traditional 20% down payment means the homeowner put in $40,000 of equity and obtained $160,000 of debt (a mortgage). So when median home prices dropped 29% to $142,000, the loan for $160,000 was now worth more than the home value.
The homeowner needed to come up with an additional $18,000 to give to the bank so that the bank recovered all of their money from the loan they gave out.
The Scary Part of a Low Down Payment Mortgage
When people learn about a low down payment mortgage, they often hear of some type of first time home buyer program that allows them to only put 3% down.
I recommend you never, EVER, do this. You never know when the market is going to crash again. If people knew the market was about to collapse in 2007-2008, they never would have taken on such high amounts of debt.
Let's look at the math of a low down payment mortgage.
Original Median Home Value: $200,000
3% Down Payment: $6,000
29% Drop in Median Home Value: $142,000
Additional Equity Homeowner Needs to Provide Bank: $52,000
If I had to guess... if you had that kind of money sitting around, you would have put a larger down payment on the house from the start. Where are you going to find $52,000?
In some areas of the country, home values dropped as much as 50%. Continuing with the example above, that would require you to come up with $94,000!
Now, don't get me wrong. Home prices can go the other way and you can make money off your home. For example, home values could rise by 29% to $258,000. After paying off your $194,000 mortgage (3% down payment), you would pocket an additional $58,000 above your initial $6,000 investment.
However, you shouldn't get your hopes up. Home values over the past several decades in the US have grown almost in tandem with inflation. It is much more likely for a severe drop than a severe increase.
Play the defensive game. There is nothing wrong with renting. If you don't have the money for a traditional down payment, continue growing your savings until you do.
Choosing a low down payment mortgage could be unbelievably harmful to your financial well-being. When it starts to sound appealing, just think back to the 2007-2008 housing crash.