Why is 20% Equity So Important For Mortgages
Written by Jason Nelson on November 19, 2018
A look back in time helps us explain today’s equity rules and the rules that apply to mortgage insurance today.
Prior to the mid 1970’s, banks were the primary provider of home mortgages. Banks required the buyer to have a 20% equity or down payment. They estimated that if they had to foreclose on a home, they would only get 80% of their investment back. That meant they would not lose money, but just break even in the event of a foreclosure. Banks weren’t willing to take risks without the buyer having a major investment in their homeownership.
That put a lot people out of the housing market. Saving 20% equity for a home was nearly impossible. The housing market was sluggish and the interest rates were high. That made financing completely out of reach for some.
Savings and Loans
Along came the Savings and Loans banking. They were willing to take less than a 20% down payment to purchase a home. But, they, too, knew that they would only recoup 80% of their investment if they had to foreclosure. In order to do that, they had to have higher interest rates to compensate for any potential losses they may incur. As they tried to lure business away from banks, they also offered higher yield rates on checking and savings accounts. They made mortgage loans available for people who were more of a risky investment. This, as we know now, Control Fraud was a slippery slope and the S&L’s failed miserably.
Now we are back where we started – except now interest rates are much higher. Buyers still needed a 20% down payment. The housing market stagnated again.
In order to stimulate the housing industry, (and make money), along came the New Mortgage insurance company. Prior to the Great Depression Mortgage Crisis, they existed as part of the banking system. After the S&L collapse, they became independent. Mortgage insurance allowed buyers with less than 20% down payment to be able to purchase a home as long as the mortgage carried insurance to protect the bank from any losses over the 80% threshold. That allowed buyers to purchase homes with as little as 5% down payment. Mortgage insurance premiums became a tax deductible item as long as the household income was less than $112,000. IRS calculated that if the household income was more than that, and buyers hadn’t saved money for a down payment, they were higher risk and offered no incentives on taxes.
The premium on mortgage insurance is based, in part, on the borrower’s credit score. The higher the score – the better the premium. Lower scores cannot only affect the interest rate on the mortgage, it can also impact the mortgage insurance premium or even if mortgage insurance is available at all.
The 80% rule still applies today. It is a “hard line”. It explains why mortgage insurance is required on your first mortgage if you borrow 80.01% of the equity in your home, and not needed if you borrow only 79.9%.
It’s not likely to go away anytime soon. Preparing for and planning your mortgage finances will better equip you to purchase a home that you can enjoy for years to come.