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FHA's 'subprime replacement' loans get tougher to land

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It's about to get tougher to qualify for a Federal Housing Administration (FHA) mortgage, often considered the replacement loan for the collapsed subprime market.

Moving to head off the financial impact of defaulting borrowers, the FHA is adding more-stringent lending requirements and higher fees borrowers must pay to get the federally-insured loans.

The announcement comes on the heels of an investigation into 15 FHA lenders with high incidences of FHA mortgage insurance claims. The same companies have reached out for government assistance -- money from taxpayers.

Mortgage insurance is paid by borrowers, typically when the down payment is lower than 20 percent. Borrowers pay, but the coverage protects lenders with cash benefits should the borrower default. When lenders foreclose against homeowners with the coverage, it triggers mortgage insurance benefits for lenders to help pay off the mortgage.

Rick Sharga Vice President of ReatyTrac says foreclosures were up 21 percent from a year ago and 120 percent from two years ago and it could get worse.

The FHA is more exposed to defaults than ever. By some estimates, as much as 50 percent of all purchase loans in some areas are FHA insured. Before the housing collapse, FHA wrote only 3 percent of all home loans.

After notice and comment periods, but beginning this spring, the FHA will raise mortgage insurance fees that borrowers must pay, cap the amount of cash that sellers can contribute for closing costs and require higher down payments for the borrowers with poor credit scores.

• The new upfront mortgage premium will cost borrowers 2.25 percent of the loan amount, up from the current 1.75 percent and the second increase in the past two years. The upfront premium can be rolled into the loan. Later, some of the cost increase could be added to a borrower's additional annual mortgage insurance premium which is paid monthly.

"Increasing the insurance premium on FHA loans is simply a reflection of the substantial risk the administration has taken on in recent years," says Nancy Osborne, chief operating officer of Erate.com, a Santa Clara, CA-based financial information publisher and interest rate tracker.

• New borrowers must have a minimum FICO credit score of 580 to qualify for FHA's 3.5 percent down payment loan, otherwise the borrower must put 10 percent down. Most lenders require a minimum credit score of about 620. A credit score is a numerical rendition of a borrowers creditworthiness. The higher the score, the better the credit and the better likelihood of qualifying for the least expensive loan.

"The absence of equity in their home has become a key predictor of a borrower defaulting on their mortgage payment in this distressed market. Requiring a greater down payment should be the first step towards more prudent underwriting and lending practices," Osborne added.

• Sellers will only be able to contribute closing costs that amount to 3 percent of the sale price, half the current 6 percent. Experts say the higher maximum encouraged borrowers to mark up the price to compensate for their concession.

The value of the FHA's reserves, $3.6 billion is down from 3 percent a year ago and an amount that's far below the amount required by Congress.

Late last year FHA proposed stiffer rules for lenders to also reduce its risk -- that lenders to have a net worth of at least $1 million in the first year and $2.5 million within three years, up from the original requirement of $250,000. The federal agency also wants tighter approval requirements and greater liability for lenders and mortgage brokers who want to originate, underwrite or service FHA.

Even with the higher fees, tougher underwriting, and lender crackdown, it's not going to be easy rebuilding reserves in a hung over housing market.

The FHA's move could further exacerbate conditions for the housing market, by removing some low-down payment loans that were allowing new buyers to buy and others to refinance their way out of foreclosure.

And the waves of foreclosures are far from over.

Sharga said over-priced homes and poor lending practices generated the first wave of foreclosures which helped trigger a recession. The recession left the nation with a 10 percent unemployment rate, which generated the second wave of foreclosures. The third wave, expected later this year will be triggered by so called Option-ARMs, adjustable rate mortgages that allow the borrower to pay less than the interest.

For many Option-ARM borrowers, with no market appreciation and no principal reduction, they have an upside down mortgage -- a loan that's bigger than the value of their home. When the Option-ARM adjusts and resets with a much higher rate and monthly payment, borrowers, unable to pay even the interest payment, certainly won't be able to afford the bigger payment.

"These borrowers won't qualify for HAMP (Home Affordable Modification Program) modifications, so if we are going to see the problem solved in 2010 it's going to have to be some kind of loan program that's not in the market yet," said Sharga.

Also see: Feds subpoena FHA lenders with high foreclosure rates

Image: FHA logo. (HUD)

For more info: 
Broderick Perkins, operates the Silicon Valley-based DeadlineNews Group digital news service. Get the feed from the Deadline Newsroom

Perkins is the National
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