SANTA CRUZ (June 1, 2008) - A home with no equity leaves lenders in a difficult position when home values fall. It is amazing that lenders ever offered 100 percent financing because the values of homes do not continue to rise without some periods of correction. In the first part of the 1990s, after our 1989 earthquake, home values declined for a few years. That was followed by the boom years 1997 - 2005.

When finances get tight, homeowners are more likely to walk away from a home that has no equity. If the homeowner quits making the payments, the lender will have to put the home up for sale in a foreclosure action with the hope of recouping as much of the principal as possible plus the expenses.

It goes without saying that when the lender finances 100% of the price of a home and then the home goes down in value, the lender will be losing money if the homeowner walks from his obligation to pay back that loan. In response to these changing conditions, lenders not only quit providing 100 percent financing but also put in place what they called a ‘declining markets’ policy. It stated that homes in declining markets would be subjected to a 5 percent reduction in maximum loan-to-value ratio loans.

In other words, if the lender’s guidelines allow 95 percent financing, the declining markets policy would restrict maximum loan amounts to just 90 percent of the home’s value. At first, lenders identified declining markets by zip codes. This would be understandable for Santa Cruz County because some of our neighborhoods have withstood the decline in real estate values better than others. However, many lenders became concerned about all of California and announced that the entire state was in a declining market.

In addition, mortgage insurance companies stopped providing insurance to lenders who lent over 90 percent of a home’s value and most lenders stopped providing second mortgages that represented over 90 percent of a home’s value. All of a sudden, prospective buyers were faced with the realization that at least a 10 percent down payment would be required in order to buy a home.

In response to an encouraging sign of a (potentially) rebounding real estate market, just this week, Fannie Mae, the nation’s largest provider of home mortgages, announced that it was abandoning its declining markets policy and would start allowing 95 percent mortgages again. Unfortunately, for most conventional mortgages over $417,000, a 10 percent down payment is still required.

The outstanding exception to this is the FHA loan. It allows borrowers to still buy a home with as little as 3 - 5 percent down and will allow a loan up to $729,750. As not all lenders are approved to do FHA loans or have the know-how to do them, be sure to ask.

This column is written every Sunday by Peter Boutell, Certified Mortgage Planner and a principal at Santa Cruz Home Finance. You may reach him at (831) 425-1250 of email him at Peter@SantaCruzHomeFinance.com.