April 24, 2000, Revised October 31, 2002, March 14, 2003, September 7, 2004, January 8, 2007
THE ERUPTION OF THE FINANCIAL CRISIS IN 2007 CAUSED SO MANY CHANGES IN THE FHA PROGRAM, AS WELL AS IN ITS PLACE IN THE HOUSING FINANCE SYSTEM, THAT I DECIDED TO WRITE A NEW PIECE FROM SCRATCH. SEEFHA MORTGAGES: A 2009 UPDATE. THIS ONE, LAST REVISED BEFORE THE CRISIS, IS RETAINED FOR ITS HISTORICAL INTEREST.
An FHA borrower in 2007 had blemished credit that was acceptable to FHA, a ratio of total debt service to income of 41% or less, doesn’t need a loan larger than the FHA maximum, which varies by county, and can put 3% down in cash.
“What type of borrower finds it advantageous to take an FHA loan?”
The answer to this question is a little different today than in 2000 when I first addressed it because FHA’s market niche is smaller. This reflects developments in the conventional sector that have not been matched by FHA, including the growth in popularity of loans with no-down payment and interest-only monthly payments, and option ARMs. Reflecting these developments, FHA’s market share fell from about 15% in 2000 to about 5% in 2006.
The FHA Market Niche in 2007
An FHA borrower:
*Has blemished credit acceptable to FHA, but not strong enough for prime pricing in the conventional market.
*Has a ratio of total debt service to income of 41% or less.
*Doesn’t need a loan larger than the FHA maximum, which varies by county. (In 2006, it ranged from $200,160 to $362,790 in the highest cost counties.)
*Can put 3% down in cash.
*Doesn’t want an interest-only mortgage or an option ARM.
Credit Requirements
At risk of oversimplifying, credit standards in the conventional market range from A+ to D-, and within that range, FHA would be about B- or C+.
FHA credit requirements overlap the higher levels of sub-prime requirements. A good illustration is the underwriting rules applicable to a prior foreclosure. With exceptions, FHA won’t accept a loan applicant who has had a foreclosure within the prior 3 years. Sub-prime lenders may have a 3-year rule for their best credit grade, but the period scales down by degrees and might be only 1 year for the lowest grade.
Similarly, the maximum ratio of total debt service to income acceptable to FHA is 41%, which is generally high relative to prime standards, but well below what passes in the non-prime sector.
A borrower who meets FHA credit standards will usually do better with an FHA than with a sub-prime loan, despite having to pay a mortgage insurance premium. The rate will be lower, the borrower will have access to a large menu of mortgages, and there are no prepayment penalties. Most mortgages in the sub-prime market are 2-year adjustables with large margins, which means a high probability of a rate increase after 2 years, and they have prepayment penalties, usually for 3 years.
FHA Loan Limits
The loan limits on FHAs are a major deterrent. HUD has asked Congress to allow the same loan amounts on FHA as on loans purchased by Freddie Mac and Fannie Mae. In 2007, this would have meant an increase to $417,000 uniform across the country.
Down Payment Requirements
In 2000, FHA’s 3% down payment compared to 5% on most conventional loan programs. In 2006, however, zero down loans were widely available in the conventional sector while the FHA minimum of 3% remained unchanged. Since zero-down loans have long been available under the VA program, FHA is now the only sector that does not have them.
This disadvantage of FHA is partially offset by down payment assistance programs available to FHA borrowers. One form of such assistance is second mortgages at preferential rates, which is the preferred method of public agencies at the city, county or state levels. These agencies have their own eligibility rules independent of FHA.
A second form of assistance is cash contributions from non-profit corporations. These have no repayment obligation, but the funds provided come from home sellers who take account of the contribution in setting their sales prices.
Neither type of assistance is a good substitute for a zero down program, a bill for which was introduced in Congress in 2004. So far, however, it has not been passed.
Interest-Only Mortgages and Option ARMs
These instruments exploded in popularity after 2000, but were not available under FHA and there is little likelihood that they ever will.
Prospects For a Revival of FHA's Market Share
Congressional authorization of no-down payment loans and a rise in loan limits would increase FHA’s market share. So would an increase in public awareness that some sub-prime borrowers would qualify for, and do better with FHA loans.
A marked increase in FHA’s market share would result from an explosion in foreclosures, which would cause a drastic restriction of lending terms in the conventional sector. This is not something I would care to see, but if it happened we will be pleased that FHA was there to help cushion the blow.
