Not everyone will welcome the above headline, but a case can be made that it is possible to make safe investments in low-down-payment mortgages and do so in a way that protects consumers from making poor choices as well.
Most folks in the real estate industry agree that the underwriting pendulum swung too far to the conservative side. I’ve written about this before, but as of yesterday it’s official – Fannie Mae and Freddie Mac are making plans to lower the required down payment from 5% of the purchase price to 3%. The low-down-payment mortgage is back.
Are zero-down or low-down-payment mortgages a good idea? Some argue that they are too dangerous and that they invite foreclosures. But is that really true?
For veterans zero-down programs have been available all along through the well-known VA program. While not all VA loans are made with nothing down, most are, (about 90% of VA loans are zero-down, according to Chris Birk, writing for AOL Real Estate) and those with a down payment typically use a small down, like 5%.
The question, then, is how much higher is the foreclosure rate for VA loans than conventional loans with larger down payments? According to Military.com, “…VA loans are a far safer bet than anything else on the market. New statistics released by the Mortgage Bankers Association’s National Delinquency Survey show that veterans using VA loans have the lowest foreclosure rate in the United States.”
Isn’t that interesting? What about other low-down programs, like FHA loans? FHA, as it turns out, has not fared nearly as well. According to a study done by Core Logic (via The Urban Institute) you can see as illustrated by the chart to the left that FHA loans have had a consistently higher delinquency rate than VA loans over time. (Delinquency in this analysis means a borrower is 90 days or more late, and is higher than the foreclosure rate as many borrowers eventually avoid foreclosure through various means.)
So how do we make “safe” low-down-payment mortgages available? The Urban Institute report goes on to speculate about why there is such a difference, and there seems to be some valuable lessons learned:
- There is a suggestion that military culture (discipline, accountability) is partly responsible, although there is no way to prove this through hard data.
- The VA directly contacts any borrower that goes into default to offer education and help. The FHA does not.
- VA loans have more skin in the game. Since VA loans require no down, and FHA requires a down payment, this doesn’t make sense at first. But FHA lenders have a 100% guarantee from FHA insurance that they will recover losses in the event of a foreclosure. VA lenders must retain a portion of the risk, and thus could be more motivated to work with a borrower in default. In other words, the lender has more skin in the game.
- VA loans are mostly held and serviced by a smaller pool of lenders, including two large organizations that specialize in working with military families – USAA and Navy Federal Credit Union. These organizations may be more effective at working with a narrow target market. FHA loans, by contrast, are serviced by a much wider array of servicers.
- VA underwriting has one requirement that is unique: the residual income test. Besides looking at debt-to-income ratios to determine affordability, the VA requires that after all household debts have been accounted for, a family have a certain amount of disposable income each month. The amount varies by location and family size, but the point is it’s an interesting litmus test to see if a family might get into trouble with their monthly commitment.
With pressure to lower the down payment requirements, will Fannie and Freddie learn from these observations by the Urban Institute? It would appear so.
Today (November 6th, 2014) Timothy Mayopoulis, CEO of Fannie Mae, clarified policy hinted at last week by Mel Watt, director of the Federal Housing Finance Agency (FHFA). In an interview with the New York Times Mr. Mayopoulis said Fannie Mae would require private mortgage insurance to cover the spread between the 20% down payment and the 3% down. In other words, private companies would have to step forward to take the first-level risk on these loans (as they do now with 5% down loans) and would be able to write their own rules for doing so.
Industry speculation is that credit score requirements would be higher, debt-to-income ratios lower, and there might be higher reserve requirements (meaning buyers would have to have more cash left over when they close.) In other words, tighten everything up a little bit and then measure the results. Hopefully mortgage insurance companies would use some form of a residual income test, although since they don’t now it’s not likely. Having the mortgage insurance companies contact borrowers soon after a default would also probably help considerably, but also isn’t likely. But you never know – maybe they will learn from others this time.
The net here is two very important developments:
- Families that are highly credit-worthy and want to buy a home – but have not yet saved up enough for a traditional down payment – may soon have one more option to get into a home now, and not later.
- The government can use taxpayer-backed funds to open up new channels for mortgage lending while shifting the lion’s share of the risk to private companies, and allowing those companies to take the risk and write the rules under which they will make the loans, and the policies under which they will service them.
If you are in the market for a home and don’t have 5% saved up yet, look for this product to be available by the first of the year.