Years ago, qualifying for a mortgage was so easy that many loan officers didn’t even bother to verify borrowers’ stated incomes. Standards were so lax that the riskiest loans of that time were known as “pulse” loans: If you had a pulse, you could get a loan. Some of the largest lenders, and 7 million homeowners, paid the price for pulse loans. Families lost their homes to foreclosure, lenders like Countrywide and Washington Mutual closed their doors, and the nation’s housing finance industry might have collapsed without massive government bailouts. To restore health to the nation’s housing finance industry, government regulators cracked down by enforcing strict lending standards. As housing markets recovered, standards have gradually loosened to make it easier for qualified buyers to get a mortgage, raising fears in some quarters that we might be returning to dangerous practices.
Others argue that regulations put in place after bust adequately protect consumers and standards that are too tight cripple housing markets and make it too difficult for buyers, especially first-time buyers, to get a mortgage. The Urban Institute estimates that tight credit standards prevented 5.2 million mortgages between 2009 and 2014.
FHA: The Lender of Last Resort
In recent years, conventional lenders have raised their credit score standards and debt requirements higher than the Federal Housing Administration’s standards, especially for mortgages with low down payments. With a credit score of 580 or higher, the minimum down payment for a 3.5% down payment is only 580. With a score of 500 to 579, the minimum down payment for an FHA loan is 10%, and borrowers with scores below 500 cannot qualify for an FHA loan. Some conventional lenders allow down payments of as low as 3% but require minimum credit scores of 620 to 640.
FHA is also more liberal in its treatment of debt. The debt-to-income (DTI) ratio compares an individual’s monthly debt payment to his or her monthly gross income. The FHA requires a debt-to-income ratio as large as 50%, where half of your monthly income goes towards paying off debts. Very few conventional lenders will approve a loan to a borrower with a DTI over 43%. Since FHA allows FICO scores that are 40 to 60 points lower than conventional lenders and DTIs seven points or higher than conventional lenders, FHA has become the lender of the last resort for first-time buyers with marginal credit and debt qualifications. In 2017, some 46% of first-time buyers used an FHA loan to buy their first home.
Even though FHA’s insurance is more expensive than the private insurance that borrowers of conventional low down payment loans are required, FHA’s business has zoomed among marginal borrowers take advantage of its lower lending standards. As a result, FHA’s loan portfolio holds loans of lower quality and higher risk than conventional lenders. The average FICO score for an FHA purchase loan in June 2019 was 675 compared to 754 for conventional purchase loans. FHA’s average DTI for purchase loans was 44% compared 33% for conventional loans.
FHA’s popularity among marginal borrowers has a downside for American taxpayers. The average credit scores for FHA borrowers fell to 670 in 2018 – the lowest average since 2008−and almost a quarter of all FHA loans in 2018 had a DTI ratio above 50 percent. Coupled with a substantial rise in cash-out refinances, FHA’s loan portfolio became significantly riskier, raising concerns in Congress.
Why Can’t High-risk Loans Be Automatically Processed?
On March 18, 2019 FHA responded by making it tougher for marginal borrowers to get approved. FHA gave notice to lenders and borrowers that changes are underway. As a first step, the agency amended its automated underwriting system to require lenders to conduct time-consuming “manual” analysis of every new loan application flagged as high risk. Compared with standard automated underwriting, manual processing is far more intensive and entails higher staffing costs and liabilities for lenders. Few marginal borrowers survive the process.
“FHA will carefully monitor the impact of this change and is preparing to implement additional changes to maintain a better balance of managing risk and fulfilling its mission,” the agency said when it forced riskier borrowers to undergo manual underwriting. Estimates of how many borrowers will be affected vary greatly and it is too soon to assess the impact of FHA’s tactic. If it doesn’t succeed in reducing the risk in FHA’s portfolio, look for greater changes in FHA’s lending standards.
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