October 4, 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.

Banks Tighten Lending By Restricting FHA Cashout Refi

FHA Loans Become Tougher To Qualify For

Effective January 1, 2009 HUD announced that any FHA cash out refinance would require two appraisals when the loan to value exceeds 85% – see FHA Takes A Closer Look At Home Values. Since the customer usually has to pay for the appraisal, this adds around $350 to the cost of refinancing with the FHA.  In addition, many underwriters are taking a very close look at appraised values, due to the continuing drop in home prices.   In turn, the close scrutiny of appraised values by the underwriters are making many appraisers more conservative in the values that they assign to a home.  The FHA also raised the down payment requirement on purchases to 3.5% and increased mortgage insurance premiums.

The net result is that an FHA loan not only has higher costs but also a higher probability of being turned down due to insufficient equity and more stringent underwriting guidelines.

Some Banks Reduce Cash Out Limits On FHA Loans

Two smaller banks today have reduced the cash out limits on FHA loans to 85% loan to value, despite the FHA guideline allowing 95% cash out.  Rumor has it that larger banks will also follow through on lowering the loan to value limits on FHA cash out refinances.   Tougher guidelines quickly spread industry wide, so expect many more lenders to make it more difficult to cash out on an FHA refinance.

Since FHA loans have a very high default rate (roughly 12%), it is only logical that banks are imposing tougher guidelines for borrowers.   The banks simply cannot afford to take on additional default risk given their weak financial position.

Many potential borrowers will continue to find it difficult to obtain mortgage approval until the economy recovers and the housing markets stabilize.  Based on the way things are going, it could be a long wait.

FHA Takes A Closer Look At Home Values On Refinances

HUD announced in Mortgagee Letter 2008-40 that effective January 1, 2009 that FHA will require a second appraisal for all cash-out refinances where the loan to value, exclusive of UFMIP,  exceeds 85% of the appraised value.  The new rule applies regardless of the loan amount or the location of the property.

The actual letter ruling reads as follows:

· Second Appraisal Requirements/Loan-to-Value Limits for Cash-Out Refinances: The instructions in ML 2008-09 regarding when a second appraisal is needed, and the requirements for that second appraisal, as well as the 85 percent limitation on cash-out refinances when the loan balance will exceed $417,000, remain in effect.

In addition, FHA will now require a second appraisal for all cash-out refinances where the LTV, exclusive of the UFMIP, will exceed 85 percent of the appraiser’s estimate of value. This second appraisal requirement applies regardless of the loan amount or the location of the property, i.e., whether the property is in a “declining area” or is not. This second appraisal requirement for cash-out refinances is effective for all case number assignments on or after January 1, 2009 and is to adhere to the instructions set forth in ML 2008-09. Please also note that cash-out refinances with LTVs exceeding 85 percent will be over-selected for post-endorsement technical reviews (PETR) to assure the quality of the underwriting.

Additional underwriting and eligibility criteria

· The subject property must have been owned by the borrower as his or her principal residence for at least 12 months preceding the date of the loan application.

· If said property is encumbered by a mortgage, the borrower must have made all of his/her mortgage payments within the month due for the previous 12 months, i.e., no payment may have been more than 30 days late and is current for the month due.

· The property that is security for the refinanced mortgage must be a 1- or 2-unit dwelling.

· Subordinate financing may remain in place, but subordinate to the FHA insured first mortgage, regardless of the total indebtedness or combined loan-to-value ratio, provided the homeowner qualifies for making scheduled payments on all liens.

· Any co-borrower or co-signer being added to the note must be an occupant of the property. Non-occupant owners may not be added in order to meet FHA’s credit underwriting guidelines for the mortgage.

The FHA has been gradually tightening various underwriting guidelines for some time now, probably due to a default rate of over 12%.

The  new regulation requiring 2 appraisals on cash out refinances will probably reduce the number of refinances done on higher LTV properties.  The customer typically pays for the appraisal when doing a refinance and the FHA appraisal usually costs $350.  A potential borrower will now have to come up with $700 just to find out if they have enough equity in the property.

Actually the rules could have been constructed to further restrict cash out lending.  Many lenders who have doubts about the value of an appraised property routinely require a second appraisal to be conducted by an appraiser of their choice.  Often times, the second appraisal will come in lower under this method.

The FHA has seen a large increase in loan applications in 2008 due to underwriting restrictions imposed by other lenders.  It will be interesting to see if these new guidelines reduce the number of FHA refinances in 2009.