October 3, 2022

FHA Mortgages and Student Loans Are a Risky Combination

First time home buyers have traditionally faced a variety of obstacles including the high cost of housing, stagnant wages, and the difficulty involved in saving for a down payment.

 

If that wasn’t bad enough, recent changes by the Federal Housing Administration (FHA) now raise another potential barrier to home ownership due to the manner in which student loan debt must be evaluated.

 

For a variety of reasons many potential home buyers with a large load of student debt are able to obtain payment deferments of various durations.   Since there was no formal payment due under the payment deferments, some of which can last for years, the FHA had for the most part simply ignored the looming certainty of future monthly payments.  By not factoring in an estimated loan payment for deferred student loans, borrowers were able to lower their debt ratios for purposes of loan eligibility.

With the new FHA requirement to account for future payments on deferred student loans, many applicants may wind up with a back end debt ratio in excess of the 43 per cent currently allowed under FHA regulations.  Potential home buyers who were close to the maximum for monthly debt payments may now find themselves ineligible for any type of mortgage loan.

Are the new FHA regulations fair to first time home buyers?

One could make the argument that the new rules make sense since at some point the borrower is going to be required to start making payments on the student loan debt and if the payment is large enough it could cause enough financial stress to put the borrower at risk of defaulting on the mortgage.   According to a HUD spokesman,  “Will that borrower actually be able to afford their loan and the student loan payment? It’s a legitimate issue to consider.  Deferred student debt is debt all the same and really must be considered when determining a borrower’s ability to sustain both student debt payments and a mortgage long term.  Our primary interest is to make certain that a first-time home buyer is put on a path of sustainable home ownership rather than being placed into a financial situation they can no longer tolerate once their student debt deferment expires.”

It’s difficult to dispute the logic of HUD’s position but it seems to fail to take into account the prospect of a borrower’s future income increasing enough to compensate for the additional student debt payment.

The problem with considering future income, however, is that incomes have been increasing at a very slow pace in the post financial crisis period.  The prospects of higher incomes for the average worker remains speculative while the certainty of having to make payments on a student loan at some point are not.  Nonetheless, the increase in the amount of student loans being handed out have been increasing at a staggering rate as students furiously borrow on the dubious prospect of obtaining a job after college that pays enough to buy a house and car, raise a family, and payoff student loans.

Those expecting an increase in the rate of home ownership are likely to be disappointed as more and more young people remain at home with their parents unable to take on the financial responsibilities of home ownership.

The excessively easy lending of a decade ago temporarily raised the rate of home ownership as totally unqualified borrowers bought houses on the theory that home values could only continue to skyrocket.  The subsequent default of these weak and unqualified borrowers resulted in millions of foreclosures which burst the housing and mortgage lending bubble which resulted in the rate of home ownership falling right back to the long term historical average of about 65 per cent.

FHA Zero Down Payment Financing Returns

Home buyers can once again purchase a home using FHA financing with a zero down payment.

Previous zero down payment FHA loan programs were funded by seller contributions funneled through a nonprofit group which then donated the down payment to the purchaser.  These seller financed down payment programs were terminated in 2008 after the FHA experienced default rates three times higher than when buyers made a cash down payment.

The innovative zero down payment FHA home purchase program was recently introduced by The Lending Company of  Phoenix, Arizona.  In order to meet the FHA required 3.5% down payment the borrower receives a 2.5% gift from a non-profit organization and the remaining 1% can be gifted from a family member. 

The Lending Company notes that the program is not a seller-paid down-payment assistance program.  To further reduce the amount of cash required by the purchaser, the seller is encouraged to provide seller concessions to cover closing costs.  A borrower receiving both gift funds and seller concessions can potentially purchase a home without putting any cash into the transaction.

The Lending Company – The One Percent Down Solution Gift Program is designed to provide eligible homebuyers a gift of up to 2.5% of the sales price to be applied towards the FHA down payment and/or allowable closing costs for the purchase of a home.

Targeted towards quality affordable housing, approved homebuyers can purchase a home for as little as 1% down payment. The program also allows for the remaining 1% down payment to be gifted from any FHA allowable source.

Program Benefits:

  • The program provides up to a 2.5% gift to FHA qualified home buyers (subject to market conditions, greater gift amounts up to 5.5% may be allowed)
  • Seller can and is encouraged to contribute towards the closing costs to further assist the homebuyer
  • Minimum credit score of 620
  • Successful credit restoration allowed

It will be interesting to see how future default rates on this zero down payment program compare to earlier “seller funded” down payment assistance programs (DAP).  The Federal Housing Finance Agency is well aware that zero down payment mortgages default at a much higher rate, as detailed in a 2007 study by the Office of Federal Housing Enterprise Oversight.

This paper extends the analysis of mortgage default to include mortgages that require no down payment from the purchaser. The results indicate that borrowers who provide down payments from their own resources have significantly lower default propensities than do borrowers whose down payments come from relatives, government agencies, or non-profits. Borrowers with down payments from seller-funded non-profits, who make no down payment at all, have the highest default rates.

Source of down payment has not previously been considered in default modeling, but the relationship between default and the source of the borrower’s down payment may be related to trigger events. Borrowers who are capable of increasing their saving, or increasing their labor earnings, in response to unforeseen events may be less susceptible to trigger events. The need to save for a down payment may serve to separate those who can more readily increase saving and earnings from those who find it more difficult.

Loans with involvement from Down payment Assistance Program’s (DAPs), which effectively had no down payment, consistently showed the highest delinquency and claim percentages. Loans with a down payment from a source other than the borrower, such as a relative or government program, had lower claim and delinquency propensities, while loans with down payments from the borrower’s resources consistently showed the lowest rates of claim and delinquency.

This paper examines the case of literally “no money from the buyer” mortgages, and finds delinquencies and claim rates much higher than those for comparable loans with cash from the borrower.

fha-format

In January of this year, a bill was introduced in Congress that would have reinstated seller funded FHA down payments to purchasers through non profit groups.   The bill was never approved but  FHA Commissioner David Stevens stated his opposition, as reported by Bloomberg:

“We’ll always listen to proposals, but Secretary Donovan has been absolutely crystal clear that he’s against the idea, as am I,” said David Stevens, commissioner of the FHA, which is under the purview of Housing and Urban Development Secretary Shaun Donovan.

Stevens said that homeowners are more willing to default if they haven’t put any cash into their purchases.

“If a buyer puts down even a few thousand dollars, it’s a lot of money for them,” he said. “There’s a financial and an emotional commitment to the home that you don’t have otherwise.”

About 13 percent of down-payment-assisted mortgages originated in 2004 have defaulted compared with about 4 percent of other FHA mortgages, according to agency data.

None of the lenders, including San Francisco-based Wells Fargo & Co. and Countrywide Bank, acquired by Bank of America Corp. in Charlotte, North Carolina, incurred any losses, since mortgages they issued were insured by the FHA, the agency said.

Programs that provide down payments to purchasers may help home sales, but past experience suggests higher default rates and increased losses for the FHA.

FHA Introduces New Minimum 580 Credit Score Requirement

The FHA is introducing new guidelines on loan to value ratios and the minimum credit score required for FHA borrowers.  As detailed in a Mortgagee Letter from the Department of Housing and Urban Development (HUD), the following credit requirements will apply for FHA borrowers, effective October 4, 2010.

  • To be eligible for maximum financing, borrowers will need a minimum credit score of 580 or higher.
  • Borrowers with a credit score between 500 and 579 will be limited to a loan to value of 90%.  A sub 580 FICO credit score borrower will henceforth need to make a 10% minimum down payment on a purchase transaction.
  • All  borrowers with a credit score below 500 will not be eligible for FHA-insured mortgage financing.

HUD’s newly introduced minimum credit score and loan to value requirements will apply  to all single family loan programs, except for Reverse Mortgages (Home Equity Conversion Mortgages) and Hope for Homeowners.

The new credit requirements are not expected to dramatically change the number of FHA mortgage approvals.  Most  lenders had already imposed a minimum credit score requirement of 640 or higher for FHA borrowers.  In limited cases, borrowers with scores between 620 and 639 could still obtain mortgage approval.

Many potential FHA borrowers with scores below 640 who cannot obtain mortgage approval may be left wondering why this is the case if the FHA has established a minimum score of only 580.  The explanation for this is that the FHA does not make mortgage loans but rather insures FHA loans made by lenders.  Despite the FHA insurance, banks do not have an iron clad protection from loss.

To protect themselves from loss exposure, FHA lenders impose various requirements that may include establishing higher minimum credit scores.   Some of the factors that influence banks in their assessment of risk on FHA loans are discussed below.

More and more banks are increasing the minimum credit score on FHA loans to attract a better overall execution (sales price) on their securities which improves profitability.  Nonetheless, the increase in the minimum credit score isn’t always about protecting the bank on a potential future loss.  In a lot of cases a bank feels more comfortable with a profit model that positions itself as a mortgage seller with a higher weighted average credit score on their pool for many other factors.

A credit score is an 18 month predictive measure of future performance but is not as reliable when a state or region is hit by some unpredictable negative economic factor.  An increase in the minimum credit score can be used as an override to protect against losses resulting from a sudden downturn in the economy.

Each bank executes a contract of sale with defined representations and warranties on their future liability.  The penalty (or loan buyback provision) is legally defined in the contract between seller and buyer of the loan.  However, not all contracts are the same with regard to liability issues.  When a loan default occurs, a post closing quality control review takes place.  If the loan originator was negligent with respect to due diligence, the bank is subject to full recourse provisions and required to repurchase  the loan which usually results in large losses to the bank.  An example of this occurred recently when Bank of America announced that Fannie Fae and Freddie Mac were demanding $10 billion of loan repurchases.

Given the complexities and potential losses to banks on the origination and sale of FHA loans, it is unlikely that banks will be decreasing their minimum credit score requirements any time soon.

More On This Topic

Sub 620 FICO Score FHA Lenders

What Are My Odds Of FHA Loan Approval With A FICO Score Below 620?

Basic Requirements To Be Eligible For FHA Financing

High Risk Mortgage Lending Still Being Promoted By GSEs

Sufficient Income Key To Sound Home Ownership

In an effort to prevent delinquent home owners from losing their homes to foreclosure, the Department of the Treasury recently issued guidelines to lenders.  Under the Making Home Affordable mortgage modification program, the Treasury stated that the mortgage loans for at risk home owners should be modified to result in a front end debt ratio of 31%.   A front end debt ratio is the percentage of gross monthly income that is spent on housing costs, typically principal, interest, taxes and insurance.

Historically, a front end debt ratio of around 31% was considered to be an affordable portion of a borrowers gross income to allocate to housing.   A housing debt ratio in this range allowed the borrower sufficient remaining income to cover other living costs and debt payments.

DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency, Joint Statement of June 23, 2009

On March 4, 2009, Treasury announced guidelines under the Program to promote sustainable loan modifications for homeowners at risk of losing their homes due to foreclosure.

Under the Program, Treasury will partner with lenders and loan servicers to offer at-risk homeowners loan modifications under which the homeowners may obtain more affordable monthly mortgage payments.

The Program guidelines require the lender to first reduce payments on eligible first-lien loans to an amount representing no greater than a 38 percent initial front-end debt-to-income ratio.6 Treasury then will match further reductions in monthly payments with the lender dollar-for-dollar to achieve a 31 percent front-end debt-to-income ratio. Borrowers whose back-end debt-to-income ratio exceeds 55 percent must agree to work with a foreclosure prevention counselor approved by the Department of Housing and Urban Development.

The OCC guidelines corresponded to comments by the Secretary of HUD, Shaun Donovan, who had previously supported lowering the debt ratios of at risk homeowners to 31%.  In response to the question as to why so many home owners re default after having a mortgaged modified, Mr. Donovan stated the obvious – if a mortgage payment was excessive compared to income, default was much more likely.

What it showed was that where there’s actually a reduction in payments, there’s long-term success for those homeowners. People do much better when you lower payments and make them affordable than these other so-called modifications, which actually keep payments the same or increase them.

So I saw it, and in fact, if you look at the report, some of the language in it directly supports the way that we’re setting up our plan to create a standard that is truly affordable for borrowers. 31 percent debt-to-income ratio is the right standard. It’s widely accepted, and if we can get to that level, as we do in our plan, we believe that that sets us up, based on the results of the study, for long-term success for homeowners.

Someone Should Tell The GSEs

The HUD Secretary’s comments make sense and reflect previous sound underwriting guidelines that existing prior to the housing lending mania of the bubble years.  If mortgage lenders had not abandoned traditional income requirements, borrowers would not have been approved at debt ratios that virtually guaranteed future defaults.   The Treasury and HUD are promoting sound lending policies when they recommend a conservative debt ratio.

The problem is that some one forgot to tell Fannie Mae (FNM), Freddie Mac (FRE) and especially the FHA what HUD and the OCC have proposed as a safe debt ratio.  (See Why Does The FHA Approve Loans That Borrowers Cannot Afford.)   We now have the absurdity of lenders being required (at taxpayer expense) to modify mortgages to a 31% debt ratio while it is extremely common to see new mortgages being approved at debt ratios of  50% or higher.   When a borrower is paying out half of pre tax income for housing expenses, there is usually barely enough left for other debt payments, living expenses, home repairs, etc.   A reduction in income, a major unexpected home repair bill or any other unexpected expense can be enough to tip the borrower into default.   Yet, the automated underwriting systems of Fannie, Freddie and the FHA are routinely approving  risky mortgage loans at debt ratios far in excess of 31%.

The government’s obsession with increasing housing sales and refinances has resulted in a bizarro world situation.    Mortgages are being approved with unaffordable payments, the borrower falls behind and then the payments are modified lower under the Making Home Affordable program.  It’s not surprising that the Federal Reserve has had to become the buyer of last resort of mortgage backed securities – who else would want to buy them?

Disclosures: No positions.

Elderly Americans Last Refinance – Reverse Mortgages

Reverse Mortgages – More Easy Lending

As originally conceived, reverse mortgages were designed to fulfill a legitimate borrowing need.  Reverse mortgages were developed for elderly Americans who had a mortgage free home with substantial equity and wanted to cash out their home equity to supplement their retirement income without having to sell the house or face large mortgage payments.

Almost all reverse mortgages are purchased by HUD and insured by the Federal Housing Administration (FHA).  FHA insured reverse mortgages are known as “home equity conversion mortgages” (HECM) and they provide the following advantages to elderly homeowners:

  • Provides supplemental cash income to elderly homeowners.
  • Does not require a monthly payment.
  • Allows the homeowner to remain in his residence until death or sale of the property.
  • Should the borrower decide to sell and move, the  amount of the loan repayment cannot exceed the value of the house.
  • HECM allows the borrower either a monthly lifetime payment (based on value of the home and age at time of mortgage closing) , a lump sum payment, a line of credit or a combination of the above choices.

In theory, the HECM made sense by allowing homeowners to remain in their homes and monetize their equity.  The lifetime HECM payment, along with other retirement income and savings would allow for a more comfortable lifestyle.  The only theoretical loser on the HECM program would be the FHA if property values dropped.

HECM Program – Theory VS Reality

The disadvantages for a borrower of a reverse mortgage are as follows:

HECM rules require a borrower to make a full draw at closing to obtain a fixed rate mortgage.  Most borrowers take the adjustable rate option and a line of credit.  The adjustable rate HECM presently has a low borrower rate of around 3.1% based on a lending margin of 2.75% and a LIBOR index of only .32%.  At some point rates will rise again and rates on the HECM could rise dramatically – the lifetime cap on the loan is over 13%.  Borrowers could see their credit lines reduced and their equity vanish quickly with higher interest rates.

Borrowing money without having to make a loan payment equates to compounding interest working against the borrower since the loan balance increases each month along with interest charges.  Borrowers who later decide to pay off the HECM and sell their homes may find that most of their equity has been lost due to accrued interest.

The HECM is a very complex product.  Despite the fact that HUD requires a potential borrower to receive financial counseling, it is unlikely that most borrowers fully understand the type of mortgage they are taking out.

The HECM is available to all those 62 or older who have sufficient equity in their homes.  HECM program lends without regard to credit or income and is strictly  asset based lending.  Do these lending criteria remind anyone of  past  disastrous mortgage programs, such as  sub prime, ALT A or Pay Option ARMs??

The fees on a HECM are very high and include an upfront and monthly mortgage insurance payment to the FHA, loan origination fees and other closing fees.  Total fees over the life of the loan can reach 12%.

A HECM does not require that the homeowner escrow for taxes  or homeowners insurance.  A known risk factor for default is a non escrowed loan.  The homeowner can face foreclosure  for not properly maintaining the property or for non payment of taxes or insurance.

The most striking feature regarding the use of reverse mortgages by elderly Americans is the large amount of equity that is being extracted upfront, leaving them with only a small future monthly cash payment as can be seen in Exhibit 3 below.

HECM CASH PAY BY YEAR

HECM CASH PAY BY YEAR

Courtesy: HUD.GOV

The reason why borrowers are taking most of their available cash out upfront is because they are using the proceeds to pay off mortgages, consumer debt, medical bills, credit cards, etc.   Borrowers run up large amounts of debt when spending exceeds income, a situation likely to continue  after the borrower taps the last dime of equity from his home.  Since the HECM was the last option available, what happens in a couple of years when the borrower is again overwhelmed by debt?

HECM – Loan Of Last Resort

The number of reverse mortgages has increased tremendously as other borrowing sources have disappeared.  Many of the reverse mortgage borrowers are retirees with limited income who would not qualify for a traditional mortgage loan under current underwriting guidelines.  In the past, many of these borrowers would have taken out a stated or no income verification mortgage.   The  large increase of HECMs starting in 2005 correlates to the time period during which no income verification loans were being discontinued.

Reverse Mortgage Volume

Reverse Mortgage Volume

Here’s an actual example of a HUD approved HECM.  Borrower has a home worth $525,000 and owes $290,000 in mortgages and other debt which will be paid off with a $350,000 HECM.  Homeowner is left with about $60,000 at closing.  Borrower has an abysmal credit score of 510 and  is 90 days past due on his current mortgage.  Income is unknown since HUD doesn’t care about the borrowers income.

Based on the credit profile and debt levels incurred prior to his approval of a HECM, what are the odds that the borrower’s finances turn around after his refinance?  My guess is that within a few short years, borrower is in heavy debt again, unable to pay the property taxes or maintenance on the property and thus facing a potential foreclosure.  Since HUD will not be throwing senior citizens out of their homes, expect a mortgage modification program for reverse mortgages and further losses to the taxpayer on another mortgage program gone bad.

More on this topic

Smarter planning would probably eliminate the need to borrow when retiring.   Bob Adams writes an informative and thoughtful blog on the challenges of successful retirement – a site worth bookmarking.

Mortgage Mod And Foreclosure Scams: Saying Goodbye To The Mortgage May Be Better

Home Sweet Home?

Home Sweet Home?

FDIC Advice Good But Too Late

The FDIC Consumer News is warning homeowners to avoid falling prey to loan modification and foreclosure rescue scams.  Many financially distressed homeowners are  preyed upon by firms that “guarantee” financial salvation, take the homeowners last few dollars and deliver nothing in return.

Foreclosure Rescue and Loan Mod Scammers Prey on Stressed Homeowners

Many homeowners having difficulty making their monthly mortgage payments are being targeted by criminals who charge large upfront fees and falsely “guarantee” to rescue a home from foreclosure.

Try to deal only with lenders, businesses and other organizations you already know or that have been recommended.

You don’t need to pay a lot of money for help or information.

“But scam artists will demand a large upfront fee, often thousands of dollars, and they do very little to actually help the homeowner,” said Robert W. Mooney, FDIC Deputy Director for Consumer Protection and Community Affairs.

Be especially suspicious of unsolicited offers that arrive via phone, e-mail or a knock on your door.

“Some companies have falsely advertised or represented that they are part of a government-endorsed mortgage assistance network

Be particularly wary of any organization that says it guarantees foreclosure relief or that it has a near-perfect success rate.

“Also be wary of anyone who promises to pay off your mortgage or repair your credit if you ‘temporarily’ sign over to them the deed to your home, because you may be permanently losing your home to a thief.”

Ironically, the job of the con men engaged in loan mod and foreclosure rescue schemes is made easier due to widely advertised government mortgage relief programs.  The lure of “something for nothing” from a government program that the con men claim to be affiliated with is one of their most successful sales tactics.

The FDIC advice comes very late for many people who would have been far better off financially had they never purchased a home beyond their means to begin with.  None of the government mortgage agencies require a potential homeowner to evaluate the true financial obligations and risks of home ownership.  Many homeowners currently obtaining government mortgages are being approved with debt ratios that almost guarantee a future default and are not in the home buyer’s best interest.

One Option For Distressed Homeowners The FDIC Does Not Mention

The FDIC offers those in financial difficulty some good advice in their newsletter but what is not mentioned is whether the homeowner should consider becoming a renter. In addition, many of the government loan mod and Hope programs, etc. have done little to put homeowners in a better financial position and many default soon after they were “helped”.

For a homeowner struggling with the mortgage, constantly spending in excess of income and living a financially depraved existence, why not look at the benefits of becoming a renter?  In many locations, renting is cheaper than owning.

Although not mentioned by the FDIC,  government makes walking away from the mortgage an easy option.  A mere two years after a bankruptcy or three years after a foreclosure,  current FHA guidelines allow a borrower to apply for mortgage financing.

Do The Math

Here are  a couple of web sites that can tell you whether it makes sense to own or rent.

payorgo.com

youwalkaway.com

More On This Topic:

Loan Modification Scams and Fraud Widespread – Mortgage Servicing News

FHA’s New Mortgage Program – Free Home Plus Trip To Vegas

100% Plus Financing Available

The American Recovery and Reinvestment Act of 2009, passed early this year, provides up to an $8,000 tax credit for first time home buyers.   The tax credit refund would be given to the home buyer after filing the 2008 or 2009 tax return.

It was only a matter of time before someone would realize that this tax credit was not helping the prospective FHA home buyers who had difficulty raising the required down payment of 3.5% for an FHA purchase.  The solution seemed obvious – let the home buyer receive the tax credit money upfront to be used for the down payment.

Last week, use of the tax credit for a down payment was officially endorsed by Shaun Donovan, secretary of the U.S. Department of Housing and Urban Development (HUD).  Mr. Donovan stated that “We all want to enable FHA consumers to access the home buyer tax credit funds when they close on their home loans so that the cash can be used as a down payment”.   Mr. Donovan noted that this is one of the ways that the government is working to “stabilize” the housing market.

Mr. Donovan’s plan may actually do more than just stabilize housing – it may set off a buying stampede, multiple offers and bidding wars at the lower end of the housing market.  Consider the following example  of a home purchase using FHA guidelines and the $8,000 home buyer tax credit.

Loan Scenario

On the purchase of a home priced at $80,000 the buyer needs the FHA required down payment of 3.5% ($2,800).  In addition to the down payment, the home buyer needs money for closing costs and prepaid items, which could easily amount to 6% of the property’s purchase price ($4,800).  The FHA also charges an upfront mortgage insurance premium of 1.75%  ($1,400).  The total amount theoretically needed by the purchaser totals $9,000.

In the real world here’s how this deal will be structured:

  • Down payment of $2,800 covered by tax credit – cost to purchaser – ZERO
  • Closing costs and prepaid items of $4,800 can and usually are worked into the purchase price since the FHA allows up to a 6% seller concession – cost to purchaser – ZERO
  • Mortgage Insurance Premium of $1,400 is added to the purchaser’s loan amount and financed by the FHA – cost to purchaser – ZERO
  • Total cash out of pocket by purchaser – ZERO
  • Cash due to purchaser for unused portion of tax credit – $5,200 – enough to easily cover a couple of weeks vacation in Vegas.
  • Based on the FHA’s default rate, approximately 15% of the new home buyers will default shortly after closing. Considering foreclosure freezes and  loan modification attempts, many purchasers can look forward to enjoying payment free housing for 2 to 3 years.

Program Benefits/Limitations

Benefits for FHA home purchaser:   Zero cash outlay to own a home,  FHA financing provided at an all time low interest rate, $5,200 cash bonus to purchaser,  plus a free long term call on the price of housing.  With these types of buyer incentives,  expect to see an increase in home purchases by the first time home buyer.

Higher incomes groups excluded:   For single taxpayers with an adjusted gross income over $75,000 and for married couples with income over $150,000, the tax credit is reduced or eliminated.

FHA 203k Program – Financing Uninhabitable Homes

Good Intentions Gone Astray?

Vacant - Please Destroy

Vacant - Please Destroy

The Federal Housing Administration (FHA) currently provides over one third of all mortgage financing.  One unique mortgage program the FHA offers is the “Rehabilitation Loan Program (203k)”.

The benefits and features of the 203k program according to the FHA are as follows:

Funds for Handyman-Specials and Fixer-Uppers

The purchase of a house that needs repair is often a catch-22 situation, because the bank won’t lend the money to buy the house until the repairs are complete, and the repairs can’t be done until the house has been purchased.

HUD’s 203(k) program can help you overcome this obstacle by enabling you to purchase or refinance a property plus the cost of making the repairs and improvements in one mortgage.

A potential homebuyer locates a fixer-upper and executes a sales contract after doing a feasibility analysis of the property with his/her real estate professional. The contract should state that the buyer is seeking a 203(k) loan and that the contract is contingent on loan approval based on additional required repairs by the FHA or the lender.

If the borrower passes the lender’s credit-worthiness test, the loan closes for an amount that will cover the purchase or refinance cost of the property, the remodeling costs and the allowable closing costs.

An iron clad rule that I have observed is that government programs once enacted never end even after they serve no useful purpose. In a different time, the 203k program made a lot of sense by revitalizing a community. It also allowed a home buyer the opportunity to acquire a property at a low price and through “sweat equity” rehabilitate the property and increase the value of the home.

Does The 203k Program Still Make Sense?

The collapse in home values and the wave of foreclosures require a reassessment of the FHA 203k program due to the huge number of vacant homes in the country.

(Bloomberg) — A record 19 million U.S. homes stood empty at the end of 2008 and homeownership fell to an eight-year low as banks seized homes faster than they could sell them.

The U.S. had 130.8 million housing units in the fourth quarter, including 2.23 million empty homes that were for sale, the Census report said. The vacancy rate was 3.5 percent in urban areas and 2.6 percent in suburbs, the report said.

U.S. banks owned $11.5 billion of homes they seized from delinquent borrowers at the end of the third quarter, according to the Federal Deposit Insurance Corp. in Washington. That’s up from $5.4 billion a year ago.

Many of the vacant homes that the FHA is lending on through the 203k program are currently empty due to the fact that they are uninhabitable (no utilities, gutted interiors, major damage, etc)  and being sold for little more than the value of the land they sit on.   Do we as a nation really need to allocate more of our limited resources to housing when we already have millions of existing vacant homes?  Would it not be more cost effective to tear down the gutted houses and put potential homeowners into a vacant home that needs minimal repairs?

Of course, once the vacant home is rehabilitated via the 203k, there is more than a 1 in 10 chance of the borrower defaulting on the new FHA loan and the home potentially becoming vacant again (See FHA – Ready To Join Fannie and Freddie.)

Why Does The FHA Approve Loans That Borrowers Can’t Afford?

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FHA Delinquency Rate Raises Questions

The latest delinquency rates reported by the FHA are troubling and raise serious questions about the qualification process for approving FHA  borrowers.   The latest FHA numbers focus on the number of borrowers defaulting within the first year of the loan as detailed in the Wall Street Journal.

Nearly 10.2% of borrowers who took out FHA-backed loans in the first quarter of 2008 had missed at least two consecutive monthly payments within the first 10 months. That was up from 2007, when 9.4% of FHA-based borrowers missed payments within the first 10 months.

But loans with seller-funded down payments, which have higher default rates, were “clearly adding to the overall losses,” said William Apgar, a senior adviser to HUD Secretary Shaun Donovan.

Congress ended the seller-funded down-payment program last fall. Loans made in 2007 with seller-funded down-payments were 60% to 70% more likely to have a 60-day default than loans made without the 100% financing, Mr. Apgar said. HUD officials told Congress that down-payment assistance programs accounted for 30% of all FHA foreclosures but just 12% of all loans.

Dubious FHA Approvals

There is obviously something very wrong with the FHA mortgage approval process when over 10% of newly approved borrowers default on payments  within the first ten months of the loan.  These borrowers should have never been approved in the first place.

The basic flaws in the FHA mortgage program have been discussed previously and center on low down payments and low credit score borrowers – see FHA – Ready To Join Fannie and Freddie. The FHA delinquency rate has exceeded 10% since 2001.  The high default rate cannot be blamed on the poor economy but rather the loose FHA underwriting standards.

The FHA goal of helping Americans to achieve home ownership is commendable but should not be done at the expense of bailouts by the American taxpayer.  The FHA is not helping those “lucky” homeowners  approved for mortgages who then discover that the financial obligations of home ownership are far greater than expected.   In this situation, the home owner becomes the loser when he should have been the winner.

By not providing long term affordable housing finance to homeowners the FHA is failing its basic mission.  To its credit, the FHA has taken some small steps to mitigate future loan losses by eliminating the seller-funded down payment program,  increasing the down payment requirement  to 3.5% and limiting cash out refinances to 85%.  In addition, the FHA has always made only full income verification loans.  The high FHA default rate, however, indicates that further initiatives are necessary.

Recommended Action To Reduce FHA Defaults

Two major initiatives that the FHA should undertake to ensure that they are not trapping potential home owners into becoming mortgage slaves are as follows:

1. Initiate a mandatory education program for first time home buyers on the risks and costs associated with home ownership.  A detailed proforma budget of all projected income and expenses should be put together to give the potential home buyer a detailed view of how realistic the goal of home ownership is and what sacrifices may be required in order to meet their payment obligations.  See Long Term Housing Stability Based On Strong Borrowers.

2.  There are many statistics and arguments being put forth as to why FHA borrowers are experiencing sky high default rates.  After cutting through the fog of confusing variables, the basic fact is that borrowers are defaulting for a very simple reason – inadequate income.   If the borrower does not have sufficient income, the odds of default increase.   Why has the  FHA not examined the correlation of income levels to default rates?

The qualifying debt ratio for a mortgage borrower is simply the the housing expense (principal, interest, taxes, insurance and mortgage insurance) divided by the borrower’s gross monthly income.  Recently, HUD Secretary Donovan stated that HUD has decided that they would seek mortgage modifications to bring a borrower’s debt ratio down to 31%, a “standard that is truly affordable for borrowers.  31% debt-to-income ratio is the right standard”. Secretary Donovan is correct and is essentially saying that the monthly housing expense should not be excessive in relationship to monthly income which is only basic common sense.

The paradox related to Secretary Donovan’s pronouncement is that FHA loans are routinely being approved at debt ratios considerably higher than 31%.  It is not unusual to see debt ratios on FHA loans well above 40% and sometimes as high as 55 to 60%.   Debt ratio approvals above 40% almost guarantee that the borrower is going to be under severe financial stress, leading to late payments and default.

The FHA is not unique in approving high debt ratio loans.  It is also routinely done by Fannie Mae (FNM) and Freddie Mac (FRE) – see Mortgages Still Being Approved For Unqualified Borrowers.

Unless the government lending agencies take a closer look at a borrower’s ability to repay, expect the cycle of mortgage defaults, foreclosures, bailouts and bank failures to continue.

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