Are 0% Loans Good, Bad, or Does it Depend? My Response

For all of you not up to speed on the topic I'm about to address, here's the short version:

1. I wrote a post that noted that 43% of first-time home buyers purchased their homes with no-money-down loans. In it I said:

These people are locking themselves into debt that will take a long, long, long time to pay off. While I agree that it's usually smarter to buy than rent, most people take this to an extreme and bite off too much house from a costs standpoint. Too many people stretch as far as financially possible to buy as big of a house as they can, and then when an unexpected financial emergency arises (which they always do), the dream home turns into a nightmare. Don't let this happen to you.

2. David, who is a mortgage broker, took exception to my post. His key comments:

The good news, behind this article, is that American Home Ownership is at the highest it has ever been! The low/zero down payment loans are a big part of this.

Certainly in some parts of the country where prices have been skyrocketing, a zero down loan would be a bad idea.

But in other parts of our country, like the Midwest and Michigan, this loan is a very valuable tool for the first time homebuyer.

I say all this to suggest that we don't throw the baby out with the bath water.

Just like everything else, a professional to help sort this all out is a good thing to have in your life.

3. I responded:

Under what circumstances would it be advisable for someone to take out a 0% down loan? I can't think of any.

4. To which he gave a lengthy response (see this link to read it all).

5. I posted it, asked people what they thought, and said I'd comment after that. This post is my set of comments on the issue.

In financial planning, given the right set of (sometimes very unlikely) circumstances, almost any financial move can be shown to be the "right" move. In my opinion, that's the case with 0% loans. If the stars align, the planets come together, and the earth stops revolving for a minute or two, then yes, it's POSSIBLE that they are a good idea.

Ok, maybe it's not that bad, but let's inspect the circumstances under which David says that 0% loans are a good deal:

• 28 year-olds who are married, have their college degrees, and have been working in their new professions for a year or so.
• Between the two of them the household income is $80,000 and the debt they have is one car loan, some student loans, and a small credit card balance.
• They must be willing to commit to the house for 3 years to break even and 5 years to have a return.
• Don't make large improvements to a home unless you intend to stay longer than 10 years. Cosmetic improvements are a plus.
• Uncle Sam is going to pay around 25% of their interest expense.
• The $140,000 house they buy is worth $175,000 in 5 years.
• The couple needs to be disciplined, have good credit, and can commit to the items above

David also made several other comments (which you can read in the link above) that aren't really central to our point of disagreement (so I'm leaving them out). In the end, his position was that there are certain cases where these loans make sense.

If that's what he wants me to admit, then I have to say that I agree with him. It is POSSIBLE for these loans to work for SOME people in SOME (very limited) cases. However, my contention is that way, way, way, way, way, way more people are getting these loans than should be getting them and they're setting themselves up for a big fall. So, for the vast, overwhelming majority of people out there, this type of loan is not a good idea.

Even David's example shows that it has to be just the right set of circumstances to be right. In particular:

• The couple is earning $80,000 a year. Is this common? No. Most couples earn well below this. In addition, the article that started this whole issue stated that the median household income of people currently getting these loans is $57,200. That's a far cry from $80,000. Already, David's example is in the small minority -- and I'm just getting started.
• The only debt the couple has is "one car loan, some student loans, and a small credit card balance." How common is this? The average American household has $5-7k in credit card debt alone. Is this "small"? How big is the one car loan? How much are "some" student loans? To me, these people sound like they are far better off than most when it comes to debt. So they are better off in both debt and income now -- making them an even smaller portion of the American public.
• They must be willing to commit to being in the house for three years. What percentage of people move in less than three years? I wouldn't say it's half, but it's a good percentage. And what about the appreciation estimates? He's using Michigan as an example (the state I live in by the way), and 4.5% appreciation might be a historical average, but I haven't seen that the past few years. And what about the fact that they need to be disciplined? Well, they've been out of school making $80k for a few years, can't afford any downpayment, and still have credit card debt. They don't sound disciplined to me.

So to me, the example used above just reinforces my point: these loans aren't for the vast majority of people. They aren't even good for a small minority. They potentially can be a good move for a fraction of the borrowing public. But it's a fraction. A small fraction. If that's what David is saying, then we're in agreement. But I'd ask him to be clear and say that this is what he believes. If he doesn't believe this, then we disagree.

Even if David believes these loans are right for 10% of the population (extreme in my opinion), what does he have to say about the fact that 43% of first-time home buyers purchased their homes with no-money-down loans? Does he condone this? It sounds like it.

Let me end with these thoughts:

1. Personally, David is a nice guy and I like him. However he does not have an unbiased point of view -- he sells loans for a living. That doesn't mean that he's a bad guy, but I would say his point of view is tainted.

2. My point of view is tainted too. I've done it a different way and that way has worked well for me. As I said in my first piece, here's what I recommend:

• Live in (or move to) a cheaper area of the country. (And after retirement, you may want to save more by retiring in a foreign country.)
• Buy a house you can easily afford, putting at least 20% down.
• Put extra payments into your budget.
• Put bonuses, gifts, second job income and all other "extra" sources of money into paying off the loan.
• Become debt free in 7-10 years.

This is what I've done and I now have no debt. Zero. Zip. And I haven't had any for almost eight years. And I'm barely over 40. How are David's clients who took out 0% loans doing by comparison? Would you rather be like them (and take David's advice) or be debt free at a relatively young age? I'll leave that decision to you as you ponder what situation you want your finances to be in in 15 years.

Comments

[Blaine Moore (Run to Win)]

Well, I don't know how common David's scenario is, but it fits my fiance and I...I am 26, she is 27 (28 in a few months), we have one car loan (sort of...it's a 0% loan for the duration of paying it off), and I have student loan debt but she does not. We have no credit card debt and my truck is paid for. We have some savings, but not a lot. Pre-tax we are right around the $80k. So, I'm not sure how uncommon his ideal couple is, but there's at least one like that that reads your site regularly.

There are a few things that differentiate us, though, and is a main reason that we don't want a 0% loan. We have some savings that we want to put towards a down payment (not enough for 20%, but 10-15% depending on the house), and our income is going to get slashed in half towards the end of the year and for the next three years while she goes back to school. We have been looking for a house for almost a year now, but we can't find something we would be willing to live in that we can afford for the 3 years on only my income and that does not involve an hour long or more commute.

Neither of us have any interest in moving to another part of the country, either; where she wants to go to school is here, where we want to live is here, and where our families are is here.

So, take that for what it is worth. I just hope we find somewhere to live that is not above a couple of smokers.

[FMF]

You don't really fit the profile he describes for two major reasons:

1) you have savings already (not that far from 20%)

2) You're not going to be at $80k for awhile. In fact, you'll be much lower very soon.

Even if you were to stay where you are, I would still opt for waiting a year, tightening down as much as possible, getting to a 20% downpayment, and buying then. That's part of my whole point. If you are someone like he mentions above, if you're disciplined, why do you need to take out a 0% loan?

[Dan]

Well, I agreed with David, and took exception to your point of view, mostly because a 0% loan worked for me. I live in the Northeast and 2 years ago it was an incredibly hot housing market. I was 24, out of school for 2 years, with 2 years at a steady job. My soon to be wife was also out of school, in her job for 5 years. Our combined pre-tax income was about 90K. We had debt: cars, student loan, credit card. No savings, because we had a wedding that we were planning. We chose to pursue a 0% down loan because we did have the ability to take a $900 per month rent payment (very common for a 1 bedroom in a safe neighborhood), add $300 to it, and afford a 0 down mortgage on a condo priced at $167,000. The extra money was not hurting us, and we lived in the condo frugally. What we were able to do was to sell the condo in 15 months at a $35,000 profit. That allowed us to put 5% down on a house, where we will stay for the long term.

As a young family, there would have been no way to save for a down payment. That extra 300 per month over the 15 months I owned the condo was $4500. That is nowhere near 20% of the purchase of the condo, which in those 15 months, appreciated out of our price range.

In our area of the country, and we do not have the choice to move as our careers (politics) are such that you are only valuable in the place where you started, it would have been impossible for us to ever get out of renting if we didn't take a 0 down loan. The lowest priced property in a safe neighborhood was $150,000 at the time I was buying. I was not going to put my family in a dangerous neighborhood, nor stay in a rental for the 5-10 years it would take to save up to make it to 20% down.

So yes, it does depend whether the 0 down loan is good or bad, but if the choice is between never getting out of the cycle of renting, or taking a 0 down loan to get yourself into a property where you can stay for a while, or make money, or both, then stop renting and take the loan.

[FMF]

Dan -- So, that was a couple years ago? How are your finances now?

[John Koontz]

I responded to your original post about my situation and 0% down loan. I still stand by my original conclusion that it does make sense for some people. And not just a very small percentage that you state.

Let's say, as a couple, you make less than $80k, as you stated. Say $60k. The house you want to buy is an average house of $200k. Assume a relatively small appreciation of 4%. That's an increase of $8000 a year. Someone making $60k has to save 13% just to keep up. And that's not including saving for retirement, which should be around 10%. You're talking about 23% savings. Most people would find that crazy! Additioanlly, that $8k is now 3.8% of the new value of the house. You have to keep doing that for MANY years before you reach the magic 20%. So why not just buy? After taxes, the cost of ownership is about the cost of renting in many parts of the US. And in many parts, it can be less. You also get the benefit of any appreciation.

Now, when you own the home, you can pay it off faster. Say you're able to pay it off at an additional $8k/year over the mortgage (and taxes, and repairs, etc...). That $8k is a larger percentage of the loan because you don't have to deal with appreciation diluting the value of the $8k. Being debt free is not dependent on the your initial loan balance, just the spead at which you pay it off.

It's really not that special of a circumstance. The only reason I would suggest not doing this, is that if you get an unusually bad interest rate (or PMI) or your location is susceptable to bubble bursting - like southern CA.

[Dan]

As a response to FMF, we currently have a very manageable mortgage payment on a house that we will be in for a long time, an emergency fund, and a plan in place to be debt free on everything but our mortgage within 4 years. If we hadn't taken our 0 down loan, we would still be renting.

One thing that we decided and accepted is that we would be willing to take on a mortgage that would be higher than a rental payment because we will stay in the house, we can improve it to add value to our asset, and we can set our financial life around the house.

[FMF]

Dan -- Congratulations. You and Blaine are two of the 900 people who've read this post so far today that 0% loans have worked out for (actually 1 of 900 since they won't work for him anymore). That's 0.1% of the readers today.

That's exactly my point. Can it work? Yes. Is it for most people? Not in my opinion -- and certainly not for 43% of the population.

[John Koontz]

Just because someone didn't respond, doesn't mean that a 0% didn't work for them.

[Michael]

Strange, my wife and I also would have fit in this category about a year before we bought our house, except without the student loans or any credit card debt. Instead, we rented for a year, saved 20% (on 80k+ per year when you're just out of college and used to the ramen-noodle budget, not that hard to do), and moved to a larger house with lower payments than our previous monthly rent.

[Margo]

The suppositions in the example above are laughable. How many couples capable of earning 80K a year will "settle" for a $140K house? I live in NC, and real estate is fairly cheap here compared to where I used to live in VA...but a $140K house is either going to be (A) small, possibly too small if those 28 year olds intend to have kids soon (B) old, and may need major repairs or (C) a long commute from work, increasing gas costs.

If a couple earning $80K and already living together (thereby splitting rent & bills) can't save for a downpayment, they simply cannot afford to own a home. It's that simple. What'll they do if/when they have a kid?

[Mark]

I live in Michigan and took out a 0% down loan about 3 years ago. Since then housing values have actually dropped in Michigan. Therefore, I am now stuck in a house with a mortgage that is greater than the value. So if I were forced to sell (job loss, illness, etc.) I would have to cover the loss with cash, which at this point I do not have. I am STUCK in my house no matter what. I made a terrible decision to take out a 0% down loan. I can't change that now, but I wish I would have known then what I know now. I listened to the common advice that you are better off buying than renting, even with 0 down. I have since changed my views on money and we are working to be debt-free, but this poor decision from 3 years ago is making that a much greater challenge.

My advice, if you don't have at least a 10% down payment, do not even think about buying a home. This 10% would at least cover the commisions if had to sell your house sooner than expected. Even better, just wait until you have 20% down....there is no hurry to purchase a home. Trust me.

[david]

I'm not sure if this sort of information will grab you or not, but there's an interesting discussion at Google Answers on how many years an average mortage is held, before it's paid off or refinanced:

http://answers.google.com/answers/threadview?id=781768

Statistics on 30 year Fixed Mortgages

I thought it would be of interest to folks.