Why Federal Down Payment Assistance and Closing Cost Reform Are Two Sides of the Same Coin
Currently, there are over 2,000 down payment assistance (DPA) programs nationwide. These programs, which are aimed at assisting first-time homebuyers (FTHBs), are primarily run by state and local governments as well as non-profit organizations.1 It’s worth noting that there is no tradition of a major federal DPA program, nor is one in place today. However, in response to the deterioration of homeownership affordability, which noticeably accelerated since the pandemic began,2 some policymakers have recently been advocating to create just such a program. The idea gained additional visibility when Vice President Harris’ presidential campaign announced it was proposing a federal DPA program with generous levels of funding.
The reality, however, is that the burden on FTHBs to save enough cash to purchase their first home goes beyond needing funds solely for a down payment, as closing costs are also a very significant upfront cash expense. As I recently wrote, there is increasing policy focus on the high level of such closing costs, which often seem to be higher than what a normal competitive market would generate.3 Surprisingly, discussions about a possible major federal DPA program have largely overlooked the topic of closing costs. This is unfortunate, as using DPA dollars to cover such costs is an eligible, and likely very significant, use of the funds. Therefore, for such a DPA program to be fully effective – i.e., deliver the most down payment help per dollar of the taxpayers’ money – it needs to be paired with an aggressive effort to reform closing costs. As I describe further below, these two topics really are two sides of the same coin.
This article acts in part as an addendum to my recent two-part series on closing costs.
The typical FTHB down payment is nowhere near the historic 20 percent level
The National Association of Realtors (NAR) reports that the average down payment by an FTHB was 8 percent in 2023. In fact, over the ten-year period from 2014 to 2023, it was even lower, averaging just 6.4 percent.4 This statistic includes, however, FTHBs with higher incomes and access to family wealth. For the target market FTHBs at which a well-designed DPA program should aim, there are lower down payment minimums readily available to potential borrowers, as specified below; for those potential borrowers who meet certain additional requirements, several targeted programs offer even further reductions in the down payment needed.5
First, Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs) that currently fund about half of America’s near-$13 trillion of first-lien mortgages, will routinely fund mortgages with as low as a 5 percent down payment.6 For those who qualify for certain specialty programs, it can go as low as 3 percent. In 2023, fully 47 percent of GSE purchase mortgages went to FTHBs.7
Second, the Federal Housing Administration (FHA), the largest government agency that helps finance homeownership, routinely insures mortgages with just a 3.5 percent down payment. Over time the FHA has gravitated toward financing mortgages with somewhat higher average credit risk than the GSEs.8 As a result, it has become the go-to source for FTHBs who need even more help to afford their first home. Consequently, in 2023, an astounding 82 percent of its total purchase mortgages went to FTHBs.9
This means that the FTHBs who are the target audience for a DPA program can currently routinely access mortgages that only require a down payment as low as 5 and 3.5 percent, and for those who qualify for specialty programs, even lower at 3 percent.
Closing costs are of comparable magnitude to FTHB down payment requirements
In my previous articles on closing costs, I estimated those paid by the buyer to be at least in the 2 to 5 percent range. A leading mortgage company estimates buyer-paid closing costs should be expected to be 3 to 6 percent of the mortgage loan amount.10 (Both are before any impact from the recent change allowing buyers to directly pay for real estate brokerage services, which might further increase their closing costs.) These are obviously of comparable magnitude to the 5, 3.5, and 3 percent minimum down payment levels. Thus, from a policy perspective, a large share of the spending by a possible major federal DPA program – perhaps as high as one-quarter or more – will inevitably be used to pay for closing costs. In fact, on an individual loan in a state with high closing costs,11 such closing costs may actually be larger than the down payment an FTHB putting just 3.5 percent down on an FHA mortgage would have to make.
Closing costs cover a long list of expenses. First, there are fees paid to private sector providers: title insurance premiums, credit report fees, appraisal fees, attorney fees, a title search fee, and likely at least several more. My previous articles on closing costs indicated how such costs are growing fast and often don’t seem to be subject to normal market competition, i.e., where consumers would search among competing firms for the best combination of price, product, and service.12 In fact, some are actually subject to reverse competition.13 In addition, there are closing costs paid to the government, such as a mortgage recording fee, an upfront FHA insurance fee (for when the loan is financed through the FHA), and a transfer tax (in certain states only).14
The effectiveness of any new federal DPA program would benefit greatly from closing cost reform
It is easy to be concerned about the potential consequences of implementing a generous federal DPA program while the current level of closing costs remains in effect. First, assuming borrowers getting DPA assistance sign up to pay the minimum required down payment of 5, 3.5, or 3 percent, a significant share of any DPA funding would go to closing costs, which, as described in my previous two-part series, are already unduly high. This would have the effect of unnecessarily siphoning off funds that could otherwise be used for actual down payments, materially reducing the impact of the DPA program. Second, having more funds available at closing might even lead to higher closing costs.15 This could divert even more funds away from assisting FTHBs with actual down payments. It is, of course, those down payments that build the net worth of FTHBs, not DPA funding being used to pay for closing costs.
The conclusion is clear: Any major federal DPA program should be paired with a comprehensive program to reform closing costs to ensure that such costs are fully at efficient and competitive market levels, and no higher. Otherwise, a major portion of the DPA’s funding – perhaps one-quarter or more – intended to help pay for FTHB down payments will in all likelihood end up being spent on inflated and non-competitively-priced closing costs. Policymakers could start the process by rebranding DPA programs as “down payment and closing cost assistance” programs as a first step to being more transparent with the public about where the taxpayer’s money would actually go.
1 See “Down Payment Assistance Programs & Grants by State 2024,” https://themortgagereports.com/33553/complete-guide-to-down-payment-assistance-in-the-usa.
2 Median household income (see https://fred.stlouisfed.org/series/MEHOINUSA646N) increased by 8.6 percent from 2019 to 2022 (the latest available). Median home prices (see https://fred.stlouisfed.org/series/MSPUS, annualized) increased by 35.2 percent over this same period, i.e., about four times faster.
3 See my two-part series on closing costs from earlier this year: “The White House’s Focus on Closing Costs: Long Overdue and Worth the Fight,” Part 1 (https://www.furmancenter.org/thestoop/entry/closing-cost-reform-long-overdue-and-worth-the-fight-part-1) and Part 2 (https://www.furmancenter.org/thestoop/entry/the-white-houses-focus-on-closing-costs-long-overdue-and-worth-the-fight-part-2).
4 See National Association of Realtors Profile of Home Buyers and Sellers, with respect to 2023, https://cdn.nar.realtor/sites/default/documents/2023-profile-of-home-buyers-and-sellers-highlights-11-13-2023.pdf and its predecessor documents for the previous nine years.
5 For the record, as of August 2024, Redfin estimates that a starter home costs on average $250,000 in the U.S. Thus, the most generous specific amount mentioned in policymaker discussions about a major federal DPA program of $25,000 would – ignoring closing costs – account for half of the historic 20 percent down payment, or 10 percent. However, the average hides tremendous cost variations across the country: the highest cost of a starter home is reported by Redfin to be in San Jose, CA, at $970,000, where $25,000 would only cover a 2.6 percent down payment, while the lowest cost is in Detroit, MI, at $70,000, where the $25,000 DPA amount would pay for a 36 percent down payment. At this time, it is unclear if the amount of DPA available would vary by local market housing costs, as opposed to being the same nationwide. See https://www.redfin.com/news/starter-home-affordability-july-2024/.
6 The historic 20 percent down payment requirement is embedded in the charters founding the GSEs, as any down payment less than that amount must be covered by private mortgage insurance (PMI) for the shortfall, i.e., a 5 percent down payment generates a 15 percent PMI policy. In such cases, PMIs will need to additionally approve the credit of the FTHB to ensure their income and other factors are adequate. (Technically, there are alternatives to PMI that can also be used, but those are very rare.)
7 See: https://ir.theice.com/press/news-details/2024/ICE-Mortgage-Monitor-First-Time-Homebuyers-Make-Up-Record-47-of-GSE-Purchase-Loans-39-of-All-GSE-Securitizations-in-2023/
8 This is because the government subsidizes the FHA at a greater level than it does the two GSEs, giving the FHA an advantage over the GSEs in serving this higher-risk market.
9 See: https://www.hud.gov/press/press_releases_media_advisories/hud_no_23_260
10 See Rocket Mortgage “Closing Costs: What Are They and How Much Will You Pay?” April 1, 2024. https://www.rocketmortgage.com/learn/closing-costs.
11 For example, California, Massachusetts, New York, etc. This is mainly due to those states having transfer taxes.
12 The General Accountability Office (GAO), a research arm of Congress, referenced this in the particular case of title insurance, stating: “Certain factors raise questions about the extent of competition and the reasonableness of prices that consumers pay for title insurance. Consumers find it difficult to comparison shop for title insurance because it is an unfamiliar and small part of a larger transaction that most consumers do not want to disrupt or delay for comparatively small potential savings…These and other factors put consumers in a potentially vulnerable situation where, to a great extent, they have little or no influence over the price of title insurance but have little choice but to purchase it.” See https://www.gao.gov/assets/gao-07-401.pdf, summary page. The same phenomenon may well be true of closing costs beyond title insurance.
13 “Reverse competition” is the name for when competition to win business is based upon increasing costs to provide economic incentives to third parties when those third parties effectively select the winning competitor on behalf of the purchaser. This was described in Part 2 of my closing cost series of papers.
14 A few additional closing costs are related to paying the home seller for things like the cost of not-yet-used heating oil in a storage tank, the pro rata share of property taxes that have been paid in advance, etc.
15 This is similar to how many analysts state that DPA programs, if large enough, will enable more households to seek to purchase homes, thereby increasing demand for owner-occupier housing that will likely lead to higher house prices. Similarly, more demand for closing-cost products could easily enable vendors to increase their prices further; this could even be amplified by the greater cash available at closings due to a generous DPA program.
