FHA Comes to the Rescue Of the Credit-Challenged

By Kenneth R. Harney
Saturday, March 17, 2007

With the subprime mortgage industry in free fall, where do home buyers with less-than-perfect credit turn for financing?

The news reports are grim. Dozens of subprime lenders closed their doors or cut back sharply on new mortgage offerings. Lenders are also severely tightening the underwriting standards that got them into trouble. As a result, many people who would have been approved for loans months ago now find all the doors closed.

But here's some potentially helpful news: There is a mortgage source that is actually expanding its business nationwide for credit-impaired and first-time home purchasers. That source is the golden oldie of the mortgage arena, the Federal Housing Administration, which recently has seen a doubling of customers refinancing out of private, subprime loans into its insured mortgage programs.

There's good reason: The FHA doesn't have problems with Wall Street investors who now see subprime mortgage bonds as toxic. FHA's bonds, by contrast, are gilt-edged and backed by the federal government so there's no shortage of mortgage money.

Equally important: FHA-insured loans are more consumer-friendly than subprime and come with interest rates roughly 3 percentage points below directly comparable subprime mortgages.

There are drawbacks, of course. FHA mortgage maximums top out just under $363,000. In high-cost markets, an FHA loan will let you buy only a modest starter home. Yet in more typical markets, the FHA's limit does not pose a problem. And the FHA's maximum loan amounts are likely to increase: Bipartisan legislation to raise the loan ceiling to the full Fannie Mae-Freddie Mac limit -- currently $417,000 -- is expected to be introduced in Congress soon, and appears to have support for passage this year.

Another drawback for some borrowers is FHA's down-payment requirement. Unlike many subprime mortgage programs, FHA does not allow consumers to buy a house without putting something into the deal. Down payments generally are 3 percent, although the forthcoming legislation is expected to lower that threshold.

Still more differences between FHA mortgages and subprime: You can't just "state" your income and get a loan with no documentation. You have to show proof that you earn what you say, and can truly afford the house you want to buy. The FHA has never offered "payment option" plans that allow borrowers to send in almost nothing every month while adding to their principal debt through what's known as negative amortization.

The FHA is not known for razzle-dazzle, so don't look for controversial "2/28" or "3/27" adjustable-rate plans that feature low payments in the first two or three years followed by sharply higher payments later. Many subprime users of 2/28 adjustables, who made no down payments, figuring they would refinance before the first reset date, now face higher costs and negative equity positions in soft housing markets.

Some of those borrowers are in serious default or heading for foreclosure. Others are bailing out of subprime 2/28s and refinancing with the FHA. Unlike private competitors, the FHA does not set rates on the basis of FICO credit scores. It underwrites loans using what it calls a "total scorecard" that examines an applicant's full credit history, employment, and nontraditional credit patterns such as rent and utility payments. It does not disqualify anyone automatically because of a bankruptcy, and it emphasizes a holistic "compensating factors" approach to credit decision-making.

If the FHA is so wonderful, why has the private subprime market boomed while the FHA's share of the market has withered, at least until recently? Part of the reason is the FHA itself. During the 1980s and '90s, the FHA developed a reputation for bureaucratic red tape, slow processing and excessive rules on mandatory repairs of properties before sale.

The FHA also did not forge ties with the fast-growing mortgage brokerage industry, which now originates nearly two-thirds of all new home loans. Instead, Wall Street seized the initiative and vacuumed up billions of dollars of broker-originated subprime loans through wholesale lenders, paying fat fees to keep the production lines rolling.

Many of those mortgages carried terms that credit-impaired applicants found hard to resist: No money down, no asset or income verification, debt-to-income ratios in excess of 50 percent, negative amortization up to 125 percent of the home's value, interest-only and other reduced-payment concepts.

Those easy-money, no-questions-asked loans for people with bad credit habits are now the dodo birds of the mortgage market. Don't expect to find them at your local broker's office. Meanwhile, the FHA is cutting out the red tape and speeding up processing; it's eager to expand its business to credit-worthy borrowers who are willing to put a little of their money into home purchases.

It's worth a look.

Kenneth R. Harney's e-mail address is KenHarney@earthlink.net.

© 2007 The Washington Post Company