A version of this article appeared on Alts.co.
Zillow did not respond to my request for comment.
Paying subscribers can access the data behind the chart here.

In late August, Zillow announced it will begin extending mortgage loans to borrowers making downpayments as low as 1%. Zillow’s bigger competitors like United Wholesale Mortgage and Rocket Mortgage started offering 1% downpayment mortgages earlier this year.

At first glance, these are risky loans. When borrowers have so little skin in the game, modest home price declines put them “underwater” (owing more on their mortgage than the value of their home). In such cases, borrowers are incentivized to default. It’s perhaps surprising Zillow is offering such a seemingly risky product in such a volatile market.

I see three motivations behind Zillow’s move. First, it’s good public relations: affordability has tanked and Zillow wants to be seen to be part of a solution. Second, the mortgage business is in the dumps, and Zillow is hoping that 1% down mortgages are a shot in the arm for their loan volumes. And third, what Zillow is offering is not especially risky. They’re actually 1% loans coupled with 2% grants, bringing the total downpayment to 3%.

These may seem like unusually levered loans. But in the context of American mortgage finance, they’re not. The median borrower puts down only 14%, and younger borrowers put down much less. Almost a third of Millennial borrowers made downpayments of 5% or less in 2022.

Instead, the 1% mortgage product elides two much more important risks lurking in Zillow’s mortgage business: fickle liquidity, and a conflict of interest with its mortgage advertisers.

In late August, Zillow announced it will begin extending mortgage loans to borrowers making a downpayment as low as 1%. The program is being piloted to qualified buyers—those with a FICO score above 620, and who earn less than 80% of their region’s median income. It’s being rolled out in Arizona to start. 

In Zillow’s telling, this is an effort to help these borrowers climb onto the property ladder earlier than they would otherwise be able to. They look at a hypothetical client of the 1% program: someone in Phoenix with 80% of the area’s median income, saving 5% of their pay, and looking to buy a $275k home. This client would only need to save for 11 months under their program—versus 31 months if a 3% downpayment was required.

Not a bad deal for borrowers

Usually, taking higher leverage on a loan entails paying a higher interest rate. But in this case, Zillow is offering the 1% downpayment loans at the same interest rates as its other products. In fact, it’s still a 3% “conventional” down payment mortgage, it’s just that Zillow is picking up 2% of it in the form of a grant to the borrower. 

Although some worry this puts borrowers into an inappropriately risky product by giving them an unsustainably large loan, this isn’t necessarily the case. 

Yes—a smaller down payment requirement allows a borrower to get a larger loan with the same amount of cash. But Zillow limits how much clients can borrow by requiring that they spend no more than half of their gross monthly income on debt (a debt-to-income, or DTI, ratio of 50%). Zillow’s illustrative client—the household earning 80% of Phoenix-area income—can’t borrow more than $300,000 without breaching Zillow’s DTI cap. 

And while financing a big asset with a small amount of equity causes the investor’s financial position to swing more aggressively as the asset oscillates in value, it’s worth remembering that one of the wonderful things about mortgages (from the borrower’s perspective) is that they offer staggering amounts of leverage without margin calls. So a bigger loan—even if it introduces more day to day volatility in a borrower’s financial position—is not necessarily a problem.

That is, from the borrower’s perspective. 

A questionable offering from Zillow’s perspective

From the lender’s perspective, these types of products certainly are more risky. Not least because the likelihood of the borrower falling “underwater”—owing more on the mortgage than the value of the home—increases with leverage, and raises the likelihood of a borrower walking away.

During the Great Financial Crisis this practice became known as “jingle mail”—millions of borrowers fell underwater and simply mailed their home keys to their mortgage lender. Research shows that every 20% increase in loan-to-value is, in terms of default risk, equivalent to a 100-point reduction in FICO score. 

It’s worth keeping in mind that Zillow is not exactly skimming the cream of the crop in terms of creditworthiness here—indeed, part of the mission is to extend loans to those who don’t have enough saved up to make even a 3% downpayment (for Zillow’s illustrative client in Phoenix, this is only $9k). 

Zillow does require a FICO score of 620, but that’s a low score; the median FICO at origination is currently 769. The riskiest 10% of borrowers have a score of 654. Only 3% of mortgages are below 620 at origination. 

To be fair, many of Zillow’s borrowers could have higher scores than 620—but not that many: Zillow caps the 1% downpayment program at those who earn more than 80% of their local area median income.

This all desperately begs the question: with so much uncertainty around the direction of home prices, why is Zillow doubling down on mortgages with such a risky product?

Pump up the volume

One motivation is likely the beneficial PR. 

While lower income and first time borrowers struggle to get onto the property ladder, Zillow can be purporting to be part of a solution. Just watch this interview with Zillow’s chief economist, who provides a masterclass in ignoring the reasonable but inconvenient question (will Zillow experience defaults when borrowers have such little skin in the game?) to focus on his talking point: Zillow is helping people get on the property ladder.

But the main reason Zillow is offering 1% down payment mortgages may be the simplest: the mortgage business is in the dumps—applications have fallen to the lowest level since the mid 1990s. Zillow is hoping that 1% down mortgages are a shot in the arm for loan volumes. 

To be clear, Mortgages are only one part of Zillow’s business—they accounted for $24mn in revenue in Q2 2023. That’s much smaller than the residential business ($380mn)—where Zillow provides marketing and customer relationship management tools for real estate agents, and sells leads to agents. But mortgages remain a big swing factor in Zillow’s financials, and it’s an area that management is trying to grow. 

Benjamin Keys, a real estate finance professor at Wharton wrote, “Zillow is fundamentally a volume-based business, so they’re looking for innovative solutions to increase some of that volume. I think of this down payment program as one potential direction for them to innovate.”

A 1% downpayment isn’t as crazy as it sounds

But what Zillow is offering here may not be as innovative—or as risky—as it first seems. 

A 1% downpayment is also closer to the norm than many realize. Although most people consider a 20% downpayment the standard, a majority of first-time buyers (64%) are putting down less than 20%, and fully one-quarter of first-time buyers are putting down 5% or less. 

And Zillow is hardly the first mover here: bigger competitors like United Wholesale Mortgage and Rocket Mortgage started offering 1% downpayment mortgages earlier this year.

The 1% downpayment offering is probably less of a source of risk than a sideshow. It’s too small to be meaningful in the US mortgage landscape. In fact, it’s too small to be very meaningful even within the context of Zillow’s mortgage business. 

Instead, the more important risks for the company derive from the far larger sum of mortgages with more typical down payments within its overall mortgage operation. In that business, it now faces two much more important risks. 

The Tinder of mortgage finance 

First, Zillow’s mortgage operation exposes it to serious liquidity risks.

Today, Zillow is not really a mortgage lender. It’s a mortgage originator and distributor. The company merely links borrowers with lenders (mostly the pension funds and insurance companies that invest in mortgage-backed securities). It’s the Tinder of mortgage finance. In the company’s own words:

“We sell substantially all of the mortgages we originate and the related servicing rights to third-party purchasers”

Here’s how it works in practice.

Zillow obtains mortgage “warehouse credit lines” from banks (JP Morgan, Citibank, and a specialized lender, Atlas SP). This is short term borrowing that provides the funding for Zillow to extend mortgage loans. These are typically structured as repurchase (“repo”) agreements—Zillow temporarily swaps mortgages to its lenders as collateral for cash.

Zillow extends mortgages to borrowers, and sells them to Fannie Mae or Freddie Mac (government-sponsored enterprises, or GSEs), or bundles them into a mortgage-backed security backed by one of the GSEs, doing so at a price above their cost of originating the loan. The proceeds from the sale are used to unwind the repo and repay the providers of the warehouse lines of credit. Zillow pockets the remainder.

The amount of time the mortgages remain on Zillow’s books (“dwell time”) isn’t clear, but the Mortgage Bankers Association suggests typical dwell times are “a few days to weeks”, with an average of 15 days.

The bottom line is that borrowers get long term loans, investors get long term investments, and the middlemen bringing the two sides together and providing the bridge financing—Zillow and the banks who provide it with warehouse lines of credit—capture the bid/offer spread between the two.

In these transactions, Zillow is greasing the wheels of housing finance without taking credit risk. Part of the reason Zillow’s chief economist refuses to answer the question about default risk is that it’s not a great look to go on national TV and say, “look, we’re not the ones holding the risk. We’re flipping these things to another investor as fast as we can.”

Focusing on the quality of the assets elides Zillow’s real risk, which resides in the stability of its funding. 

Problem 1: Can Zillow hold the reservation?

Banks that extend loans to poor credits ultimately become insolvent—their assets fall below the value of their liabilities. But in most cases, the actual nail in the coffin comes from those who lend to the bank taking flight. To pick just one recent example: Silicon Valley Bank had highly questionable assets on its balance sheet, but it was depositors fleeing en masse that brought about the bank’s demise.

It’s no different for “nonbank” mortgage originators like Zillow—except their sources of funding are not depositors but the warehouse lenders. The most notorious “bad lender” of the Great Financial Crisis—Countrywide financial—made exorbitantly big loans to wildly unqualified buyers. But the company was ultimately brought to its knees by its warehouse lender—Bank of New York—making a margin call. 

The FDIC’s take is worth quoting at length here (my emphasis):

The nonbank structure is vulnerable to liquidity and funding risks. The new post-crisis generation of nonbanks seem vulnerable to liquidity pressures similar to those that nonbanks were subjected to during the financial crisis. Nonbanks depend on short-term credit, particularly warehouse lines of credit provided by banks. This funding can become more expensive and less accessible when financial market conditions tighten, and this tightening alone can cause the nonbank to go out of business. In times of stress, warehouse lenders face strong incentives to cancel lines of credit and seize collateral as quickly as possible.

To paraphrase Jerry Seinfeld: anyone can make the loans—it’s the holding of them that matters. 

Zillow’s ability to hold onto risky mortgages—even temporarily—is subject to the whims of the market. Zillow’s identified this as a key risk in their 10-K:

“These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including…our ability to operate and grow Zillow Home Loans, our mortgage origination business, including the ability to obtain or maintain sufficient financing and resell originated mortgages on the secondary market.”

Zillow can happily originate mortgages while markets are well-functioning. Everything will go swimmingly—until asset prices start to fall, lenders make margin calls, and Zillow is forced to liquidate mortgages at fire sale prices to meet those calls. Again, from the 10k: 

“The master repurchase agreements contain margin call provisions that provide the Lenders with certain rights in the event of a decline in the market value of the assets purchased under the master repurchase agreements.”

Liquidity could blow up in Zillow’s face one day—or, it might not, at least for a sufficiently long time that by the time liquidity does become an issue, the company’s balance sheet is sufficiently fortress-like to survive. 

In the meantime though, Zillow’s foray into mortgages is steadily coming into conflict with its raison d’etre: aggregating the transactions between real estate market participants. Herein lies the second risk posed by Zillow’s mortgage business.

Problem 2: Zillow can’t have its cake and eat it too

Zillow now does a lot of things, but is fundamentally an aggregator: it brings buyers and sellers together in one spot, coasting off network effects, a monopoly on buyer attention, and in theory, returns to scale.

The problem is that most of Zillow’s major lines of revenue are not infinitely scalable. 

Take their original primary source of revenue, and one that still accounts for a large share: advertising. Zillow places ads for vendors on its listing pages. But, to the extent listings are limited (especially these days), Zillow can’t expand its advertising without degrading the user experience.

Maybe more importantly, these days Zillow is making more of its revenue from selling leads to its “Premier Agents”. But here, too, we might wonder about its scalability. 

Consider how this business works: agents pay Zillow for leads; the more they pay, the more leads they get. But it’s a competitive auction: when more agents are bidding for leads, the clearing price goes up. Unless Zillow can indefinitely expand its supply of leads—and there is no reason to think it can—after some point in time, the cost per lead will bump against the economics of the industry: there is a limit to how much agents will pay for a lead. 

Between a rock and a hard place

Zillow is subject to the demands of being a publicly-traded company. It needs to grow. This helps explain the foray into mortgages. 

But expanding mortgages risks bringing it into conflict with its clients, who also do that business. Again, from Zillow’s 10-K:

“Our recent entry into the mortgage lending business may also cause a negative reaction within the mortgage industry, including among some of our mortgage advertisers, which could harm our reputation, results of operations and financial condition.”

This is similar to the error Zillow made with Offers (Zillow’s iBuying business)—as Ben Thomson writes, “Zillow Offers was the exact same category of mistake: the company sacrificed its horizontal position in the pursuit of vertical integration, ultimately making itself into a worse Aggregator.”

Moreover, it’s not clear Zillow has any real advantage in the mortgage business. Just like it lost out in iBuying to Opendoor—a business that specializes in that line of work—in the mortgage business, Zillow remains a minnow compared to competitors like Rocket Mortgage. 

As Mike DelPrete points out, in order to make meaningful inroads in the mortgage business, Zillow will have to both expand its Premier Agent programme, and attach mortgages at a higher rate than they have been thus far. This is no easy task—at the very least, it’s expensive. Zillow’s mortgage business posted a $167 million loss in 2022, and has generated a cumulative loss of $283 million since 2017.

Picking up pennies in front of a steamroller

Zillow’s 1% down payment business is not a big risk for the company—1% loans are not especially dicey, and even if they were, Zillow is doing them on too small a scale to move the needle on the company’s risk profile.

The much more important risks for Zillow are two-fold. First, liquidity can be fickle—Zillow’s mortgage origination may be picking up pennies in front of a steamroller. Second, Zillow may be feeding its investors’ appetite for growth by cannibalizing its other lines of business. 

Further Reading

• Strategist Mike DelPrete on Zillow doubling down on the mortgage business

• Ben Thomson on Zillow’s business model

• Wharton Professor Benjamin Keys on Zillow’s motivation for 1% downpayment mortgages

• Zillow’s most recent group presentation

• The FDIC’s report on risks for nonbank lenders