Why Zero Down Payment Loans Can Be Risky

Mortgages that don't require a down payment help many people purchase a home they otherwise wouldn't be able to afford. That's very good news. But no-down payment mortgages have additional risks that borrowers should understand before they obtain such financing.

What is a down payment?
A down payment is simply a percentage of the home's purchase price. For example, a 10-percent downpayment on a $250,000 home would be $25,000. A down payment also can be expressed as a "loan-to-value ratio" or LTV. A 10-percent down payment would be equivalent to a "90-percent LTV."

The buyer's down payment becomes the new homeowner's initial "equity" in the home. (Equity is the value of the home minus what's owed on the mortgage.) For example, if you borrowed $180,000 to buy a $200,000 home, you would have $20,000 of equity. If you borrowed $200,000 to buy that same home, you would start out with zero equity in the home.

Zero money down can increase your loan costs
No-down payment mortgages are riskier for the lender since the borrower doesn't have any ownership stake in the home and could become "upside-down" if the value of the property dipped below the purchase price. That's why high-LTV loans typically are more costly than loans that require a larger down payment.

A down payment that's less than 20 percent of the home's purchase price triggers the need for either a second loan, called a "piggyback," or mortgage insurance, which protects the lender if the borrower defaults. Either option adds to the borrower's costs of owning the home.

Why having no equity can be risky
Homeowners who don’t have equity can't borrow against their home to remodel, add on or make repairs to the home or for such personal reasons as a family emergency, medical expenses or college tuition. Refinancing may be difficult as well.

Lack of equity can be a bigger problem if the homeowner needs to sell the home because if the value of the home has dipped, the sale price might not be enough to pay off the mortgage. If the value of the home stayed the same, a seller with no equity would have to pay the transaction costs out of his or her pocket. That's why soft housing markets make no-down payment loans more risky for lenders and borrowers.