Escrow-free loans raise credit-risk questions

Do you really need an escrow account attached to your mortgage? Aren’t you capable of remembering when it’s time to pay tax and insurance bills? These questions suddenly are more controversial than you might guess.
A new program offered by one of the country’s highest-volume lenders allows a wide swath of borrowers to say no-thanks to escrow accounts, at no charge. More importantly, the escrow-free option is open to borrowers who have dings in their credit histories and are making small down payments.

Traditionally, borrowers granted waivers from mandatory escrow accounts have had good to excellent credit scores and substantial down payments — often 20 percent or more. Opening the door to escrow-free status for borrowers who don’t fit this profile is raising eyebrows in the mortgage field. Michael Fratantoni, chief economist for the Mortgage Bankers Association, told me it would be “a troubling development” if large numbers of new buyers with sub-par credit opted out of escrow accounts, exposing them to potential problems down the road.

A little background here: Escrow (or impound) accounts are standard features on many conventional home mortgages in the U.S. They require the borrower to deposit money in advance for later payment of local property taxes and hazard-insurance premiums by the lender or loan servicer. The idea is that individual borrowers are more likely to forget — or otherwise fail to pay — insurance and tax bills that come due annually or semi-annually. Failing to make those payments exposes the property to foreclosure, endangering the lender’s collateral and the owner’s equity.

Waivers of escrow requirements are possible for borrowers who meet lenders’ criteria on financial capacity and credit, subject to a fee — often one-quarter of a percent of the loan amount.

A program now being introduced by United Wholesale Mortgage, the country’s largest wholesale lender, departs from the traditional approach to escrows: It allows conventional loan applicants who have significant dings to their credit — FICO credit scores of 640 — and who make down payments as low as 5 percent to avoid escrow accounts. The loans are being originated for sale to Fannie Mae and Freddie Mac, the big federally regulated mortgage investors. FICO scores for home-purchase loans at both companies average in the 750s, according to data and software vendor Ellie Mae. UWM has a network of 7,000 brokerage firms with 30,000 individual loan officers, according to the firm. Unlike banks or mortgage companies that have retail operations, wholesale lenders purchase loans originated by third parties, typically brokers.

The idea behind escrow-free loans, according to UWM, is to slash costs. On a hypothetical $300,000 first mortgage, borrowers could save $3,625 — $750 that would otherwise be paid at closing for an escrow waiver fee, $2,500 on deposits for property taxes and another $375 for insurance premiums.

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But aren’t there inherent extra risks when buyers with low cash and sub-par credit scores handle their own tax and insurance payments? During the super-easy credit years preceding the housing bust — no or minimal down payments, no documentation, super low credit requirements — many of the subprime loans that ended up in foreclosure had no escrow accounts. When hard times hit, those borrowers found it difficult to come up with large, lump-sum tax and insurance payments and frequently lost their homes.

Mat Ishbia, president and CEO of UWM, told me in an email that this is not the scenario ahead for his company’s new program. “These are all high-quality borrowers that are approved through automated engines at Fannie Mae and Freddie Mac, and verified by our underwriters.” The program saves money and “it’s better for consumers to have options,” Ishbia said.

For its part, Fannie Mae permits waivers under specified guidelines but had no comment on UWM’s loan option. Freddie Mac also had no comment on the program.

Some experts on escrow accounts are highly critical of the idea, however. David I. Ginsburg, president of Loantech LLC, a national authority on escrow account audits, says UWM’s program “sounds like we are back in 2008 again. When the next slowdown occurs, those borrowers will have problems, and we know what that will look like.” Paul Skeens, president of Colonial Mortgage Group of Waldorf, Maryland, called the program “foolish.”

What to make of all this? No question the upfront savings are attractive, especially for cash-short first-time buyers. But they better keep track of their tax and insurance due dates, and build up rainy-day financial reserves to handle economic rough spots ahead.