First-time and move-up home buyers with heavy debt loads, low credit scores and small down payments face a daunting new mortgage hurdle: The Federal Housing Administration is toughening its underwriting standards. Large numbers of applications could be turned down in the coming months as a result.
Industry estimates vary about the impact of the agency’s abrupt changes, but mortgage company executives told me last week that they are bracing for reductions in their FHA business by anywhere from 10 percent to 30 percent.
Here is what’s happening: For several years, the FHA has insured loans to buyers who previously would have been considered too risky or marginal at best. Those applicants often carried crushing monthly personal debts — for credit cards, auto loans, student loans and other obligations — totaling more than half of their monthly incomes. Many also had histories of credit problems that lowered their credit scores. Combined with skimpy down payments of 3.5 percent and minimal bank reserves, these borrowers have a high statistical probability of defaulting on their loans.
To prevent big losses to the FHA’s insurance fund, the agency recently informed lenders nationwide that from March 18 onward, it would apply more stringent standards to applications from high-risk home buyers. In its letter, the FHA documented its reasons for the crackdown. According to FHA Commissioner Brian D. Montgomery, the agency has been seeing disturbing trends in the quality of loans that lenders have been delivering to it:
●Nearly 1 in 4 approved home purchasers had a debt-to-income (DTI) ratio exceeding 50 percent, the worst since 2000. In January, 28 percent of buyers were in that category.
●FICO credit scores are tanking. They have fallen to the lowest level since 2008 — an industry-low average of 670. In the first quarter of fiscal 2019, more than 28 percent of all new purchase loans had FICOs below 640. In the same quarter, more than 13 percent of new loans had scores under 620 — 19 percent higher than the same period in the previous fiscal year. (FICO scores range from 300 to 850; low scores predict higher risks of nonpayment. Average scores for purchasers at giant mortgage investors Fannie Mae and Freddie Mac average around 750.)
●Borrowers are siphoning equity from their homes at an alarming rate. In fiscal 2018, FHA saw a 60 percent increase in “cash-out” refinancing as a percentage of all refinancings. Cash-outs allow borrowers to convert equity into spendable money.
●Growing numbers of loans have multiple indications of serious future risk of nonpayment — combinations of credit scores of 640 or less and DTI ratios that exceed 50 percent.
Given these omens, the FHA clamped down by amending its automated underwriting system. Lenders must now conduct time-consuming “manual” analysis of every new loan application flagged as high risk. Compared with standard automated underwriting, manual processing is far more intensive and entails higher staffing costs and liabilities for lenders. Many balk at it. Some investors refuse to buy manually underwritten loans. As a result, fewer of them make it through the process.
John Porter, vice president of Mortgage Master Service Corp. in Kent, Wash., predicts that the FHA’s abrupt rule change will slash the number of FHA loans approved nationwide by anywhere from 20 percent to 30 percent in the coming months. Other lenders believe the decline will be smaller. Paul Skeens, president of Colonial Mortgage Group in Waldorf, Md., says a 10 percent drop-off is more likely. But most lenders agree that substantial numbers of borrowers hoping to qualify for FHA’s liberal down-payment and credit terms face rejections they wouldn’t have encountered under the old rules.
“Absolutely they’re going to turn a lot of loans down,” Skeens said. Joe Metzler, a loan officer at Mortgages Unlimited in St. Paul, Minn., welcomes the stricter standards. “FHA has become the dumping ground for crappy [loan] files with ridiculous DTI allowances and bad scores,” he said. “A lot of it lately has been straight-up subprime. We should not be doing them.”
According to FHA, nearly 83 percent of its home-purchase loans in January went to first-time buyers. Just under 40 percent went to minorities. Those who have the weakest financial profiles — FICO scores under 640 with debt ratios above 50 percent — could be shocked when they go to buy a house this spring. They may have to turn to subprime lenders who charge much higher interest rates, or they may have to simply postpone their purchase until they’re in better financial shape.