Sunday, January 8, 2012

Paul Krugman on the Value of a Down Payment

Contrary to a belief held by some, urbanists are not necessarily against home ownership. We just would prefer it if more home ownership happened in a way that were compatible with the efficient use of land, walkability and the ability to support convenient transit service (i.e. condos, townhomes or small lot homes instead of large-lot homes). We also don't disparage people who choose to rent. That's one reason why something in The Return of Depression Economics by Paul Krugman caught my eye.

He points out that down payments on homes are more than just a way to demonstrate the financial ability to pay the mortgage and reduce the total interest paid on the loan. They also provide a critical protection to the home buyer in case the value of the home drops.

Let's take an example. Say you want to buy a median priced condo in Los Angeles County. The November 2011 median price for LA County condos was about $275,000. So assuming you put the traditional 20% down, your down payment is $55,000. That means you have to take out a mortgage for the remainder: $220,000.

Now let's say, despite your highest homeownerish hopes, the price of your condo then falls. Say it falls by 10% in one year because of an economic crisis. Now your condo is worth $247,500. However, if you have been making your mortgage payments, you now owe a bit less than $220,000 on it. If you had put no money down, you would likely be underwater, owing more on the mortgage than the condo is worth. Being underwater is not a trivial problem in the current US economy. It can make it hard to move to chase a new job and it can sap consumer confidence. More than ten million Americans are currently underwater on their mortgages.

I hope it's obvious to everyone by now that during the housing boom mortgage originators made lots of questionable loans to people. They loaned to people who couldn't afford the payments and they loaned with low or no down payment. Then they sold the loans to investors and washed their hands of the whole business. It didn't matter to the originators financially whether the mortgages were solid in the long run. It all seemed fine to many when housing prices were rising. We would do well to remember that housing is a good, and like any other good it can go up or down in price based on market conditions. There is no covenant with God that your home will always rise in value.

So just remember to save for that down payment if you want to be a homeowner. And please please please please please remember that you shouldn't sign up for a mortgage unless you can afford the payments and have some emergency savings available. If more people had done that we wouldn't be in the worst economic slump since the Great Depression.

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