Risky home loans led to the 2008 housing crisis and the subsequent Great Recession. Regulators and lenders quickly tightened mortgage-underwriting standards to prevent future crashes. Have we forgotten the roots of the housing crisis in just over a decade?
The Federal Housing Administration (FHA) thinks so and has taken action to reverse trends showing increased mortgage loan risk. As of March 18, the agency amended its automatic underwriting system to mandate that all loans identified as high-risk must go through a separate manual analysis. That's bad news for homebuyers struggling to enter the housing market.
FHA loans are targeted for the higher-risk market, offering low 3.5% down payments to homebuyers with FICO scores of at least 580. Scores as low as 500 may still qualify with a 10% down payment and other mitigating factors. FHA loans also require debt-to-income (DTI ratios) less than 43%, although DTIs of 50% and above can qualify in certain cases.
In 2016, the FHA loosened underwriting standards and lifted the rule that loans with DTIs above 43% and credit scores below 620 must be manually underwritten. Since then, FHA has spotted worrisome trends that forced the reversal.
Overall, credit scores for approvals are dropping. The average score for an FHA loan fell to 670, the lowest average in a decade. In the first quarter of fiscal 2019, over 13% of new FHA loans had scores below 620 – a 19% increase over the same period in fiscal 2018.
Meanwhile, more approved borrowers have credit scores below 640 combined with a DTI above 50%. Almost one-quarter of FHA loans in the last fiscal year were given to borrowers with DTIs above 50%.
An increasing number of FHA loan holders are tapping into their home equity for cash, sinking further into debt. In 2018, cash-out refinancing increased by an alarming 60%.
FHA tried to open the housing market to more potential buyers – but sometimes borrowers simply can't afford the house they want to buy right now. Extra scrutiny of high-risk loans should separate the risky from the irresponsible.
Approximately 5% of FHA-insured loans will be affected by the change (around 40,000 to 50,000 loans). That doesn't sound unreasonable – unless you're one of the 40,000 to 50,000 potential homeowners who could be denied due to tighter standards.
What can you do if you're affected? You can try to qualify for a less expensive home that would lower your DTI ratio – but, ultimately, you need to reduce debt and raise your credit score to improve your finances for a future home purchase.
Start by making sure you have the credit score you deserve. Check your credit report for errors or any signs of fraud or identity theft that could be dragging down your score. You can check your credit score and read your credit report for free by joining MoneyTips.
Next, set up a long-term plan to buy a home at a future date, starting with a revised budget. To reduce debt and save for a larger down payment, you have to spend less than you make each month – not easy, but necessary.
Once your budget is in place, stick to your plan. When you're tempted by other uses for your money, remember your long-term goal of a new home.
The FHA may change direction again and allow you to qualify for a loan. Don't count on a change anytime soon. Even if underwriting standards loosen again, one question remains. Can you really afford the home you're about to buy? A lender may be willing to give you a loan, but that doesn't mean that you have to take it – especially if you're on the financial edge.
MoneyTips is happy to help you get free mortgage and refinance quotes from top lenders.