June 12, 2024

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


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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