With the subprime mortgage industry in virtual free fall, where do home buyers with less-than-perfect credit turn for financing?
The news reports are grim: Not only have dozens of subprime lenders closed their doors or cut back sharply on new mortgage offerings, but they’re also severely tightening the loose underwriting standards that got them into trouble. As a result, many people who would have been approved for a loan months ago now find all the doors suddenly closed.
But here’s some potentially helpful news for consumers: There is a mortgage source that is actually expanding its business nationwide for credit-impaired and first-time home purchasers. That source is the golden oldie of the mortgage arena — the Federal Housing Administration (FHA), which recently has seen a doubling of customers refinancing out of private, subprime loans into its insured mortgage programs.
There’s good reason: FHA doesn’t have problems with Wall Street investors who now see subprime mortgage bonds as toxic. FHA’s bonds, by contrast, are gilt-edged and backed by the federal government, so there’s no shortage of mortgage money.
Equally important: FHA-insured loans are more consumer-friendly than subprime, and come with interest costs roughly 3 percentage points below directly comparable subprime mortgages.
There are drawbacks, of course. FHA mortgage maximums top out just under $363,000. In the very highest-cost markets, an FHA loan will only let you buy a modest starter home. Yet in more typical markets around the country, FHA’s limit does not pose a problem. And FHA’s maximum loan amounts are likely to increase: Bipartisan legislation to raise the loan ceiling to the full Fannie Mae-Freddie Mac limit — currently $417,000 — is expected to be introduced on Capitol Hill shortly, and it appears to have support for passage this year.
Another drawback for some borrowers is FHA’s down-payment requirement. Unlike many subprime mortgage programs, FHA does not allow consumers to buy a house without putting something into the deal. Down payments generally are 3 percent, although the forthcoming congressional legislation is expected to lower that threshold.
Still further differences between FHA mortgages and subprime: You can’t just “state” your income and get a loan with no documentation. You’ve got to show proof that you earn what you say and can truly afford the house you want to buy. FHA never has offered “payment option” plans that allow borrowers to send in almost nothing per month while adding to their principal debt through what’s known as negative amortization.
FHA is not known for razzle-dazzle, so don’t look for controversial “2/28” or “3/27” adjustable rate plans that feature low payments in the first two or three years followed by sharply higher payments later. Many subprime users of 2/28 adjustables, who made zero down payments figuring they’d refinance before the first reset date, now face higher costs and negative equity positions in soft housing markets.
Some of those very borrowers are in serious default or heading for foreclosure. Others are bailing out of subprime 2/28s and refinancing with FHA. Unlike private competitors, FHA does not set rates on the basis of FICO credit scores; instead, it underwrites loans using what it calls a “total scorecard” that examines an applicant’s full credit history, employment and nontraditional credit patterns such as rent and utilities payments. It does not disqualify anyone automatically because of a bankruptcy, and it emphasizes a holistic “compensating factors” approach to credit decision-making.
You might ask: If FHA is so wonderful, why has the private subprime market boomed while FHA’s share of the market has withered — at least until recently? Part of the reason is FHA itself. During the 1980s and ’90s, FHA developed a reputation for bureaucratic red tape, slow processing and excessive rules on mandatory fix-ups of properties prior to sale.
FHA also did not forge ties with the fast-growing mortgage brokerage industry, which now originates nearly two-thirds of all new home loans. Instead, Wall Street seized the initiative and vacuumed up billions of dollars of broker-originated subprime loans through wholesale lenders, paying fat fees to keep the production lines rolling.
Many of those mortgages carried terms that credit-impaired applicants found hard to resist, especially in comparison to what FHA offered: No money down, no asset or income verification, debt-to-income ratios in excess of 50 percent, negative amortization up to 125 percent of the home’s value, and interest-only and other reduced-payment concepts.
Those easy-money, no-questions-asked loans for people with bad credit habits are now the dodo birds of the mortgage market. Don’t expect to find them at your local broker’s office. Meanwhile, FHA is cutting out the red tape, speeding up processing and is eager to expand its business to credit-worthy borrowers who are willing to put a little of their money into home purchases.
Ken Harney is a real estate columnist with the Washington Post.