August 7, 2017
Sometimes our brokers ask their branch manager, “Why is the cost for a loan with 20% down more expensive than a loan with 10% down?” The answer is, “Risk mitigation.” While it is true that a person who puts more money down is less likely to go into foreclosure, the housing crisis showed many families who lost their homes had purchased it with 20% down or more.
The cost of foreclosure for any lender is typically greater than 30% of the loan amount. The losses to a lender for a loan that originated as an 80% mortgage are greater than the losses for a loan originated at 90% mortgage.
Wait…what? The math works out if you factor in private mortgage insurance. The loss is less for a loan with less down. Remember the purpose of mortgage insurance is to reimburse the lender a certain percentage of the loan amount should it go into foreclosure, typically 65% of the original loan balance.
Let’s say Jim and Wilma are purchasing homes next door to each other for $400,000. Jim is putting 20% down for a $320,000 mortgage and Wilma is putting down 10% for a $360,000 mortgage. Wilma is required to have mortgage insurance that adds to $132 per month to her payment, but it covers the lender for 25% of the original mortgage ($90,000).
The cost to a lender, should Jim be foreclosed on, is about $96,000. Add the cost of the foreclosure to the loan balance and the total is $416,000. Even if the loan balance has decreased and the home value has increased, there is little room for a lender to break even.
Now if Wilma goes into foreclosure, the cost to the lender would be about $108,000 but the lender will get a check for $90,000 (from the mortgage insurance) and the lender will lose $18,000. This is if Wilma defaults on the first day of the loan and there is no change in property value.
There are of course a variety of factors that could also come into play with the Jim and Wilma saga that could change the bigger picture. The bottom line, however, remains the same: the lower the risk, the lower the cost of the loan. And Orion’s brokers need to understand this.