After the subprime mortgage crisis, the housing market tightened significantly, in part through more stringent government regulation and in part through self-preservation by financial institutions. Simply put, banks could no longer afford to bundle or hide extremely risky loans and underplay the risk.
As a result, many homeowners who would have qualified for loans were left in the lurch, especially those with low credit scores and/or minimal down payment money. Traditionally, government programs like the FHA loan program would help to fill the gap, but even lenders participating in FHA loans were operating with an abundance of caution.
However, there are signs that lenders are beginning to ease requirements on FHA loans. According to Inside Mortgage Finance as reported by the Los Angeles Times, the average credit score on FHA loans has been declining and the debt-to-income (DTI) ratio has been rising. The DTI ratio is particularly important, since it represents a measure of how much of a borrower's income is required to cover all housing payments, and therefore their ability to repay the loan.
FHA rules allow for credit scores of 580 for maximum financing with the minimum down payment of 3.5% (compared to a typical 20% down for a conventional mortgage), and could dip lower with a higher down payment and a limited loan-to-value (LTV) ratio.
Similarly, for the DTI ratios, the preferred maximum front-end ratio (housing expenses divided by income) is 31%, and the preferred maximum back-end ratio (all monthly expenses including housing divided by income) is 43%. On a case-by-case basis, these can be as high as 46.99% and 56.99% respectively.
Most lenders set higher limits, but the FHA loan will almost always have lower thresholds than the lender's non-FHA mortgages, thanks to government backing. For a frame of reference, at the beginning of 2014, the average FHA-loan credit score was 701 and the back-end DTI was 38%. At the end of January 2014, the average credit score had fallen to 680 and the back-end DTI rose to 40.3%.
Some loans are being approved on a case-by-case basis with a credit score approaching 600. While that isn't overtly dangerous, it does represent that lenders are willing to take more risks. So the question is: is this good news or bad news?
Certainly, this is good news if you are a prospective homebuyer, but you must be careful in correctly assessing your ability to repay. It is rare that anyone turns down a loan offer from a mortgage lender saying, "Thanks, but I'm afraid I can't repay this."
Some analysts believe that less scrupulous lenders may use the FHA program as a means to increase their business and inadvertently create another housing bubble within FHA. That is certainly possible, but not likely. For one reason, lenders cannot have too many mortgages go into default or they will lose their status as approved FHA lenders. That may not stop a few lenders from pushing things too far, but the effect is unlikely to cause a broad collapse.
A further check is provided by the new rules issued by the Consumer Finance Protection Bureau (CFPB) that establish the Qualified Mortgage (QM) rules and Ability-to-Repay (ATR) guidelines for lenders. Lenders are free to make loans that do not follow these guidelines, but it is generally not in their best interests to do so.
Are we headed back toward another housing bubble and mortgage crisis? In any election year, there will be political pressure to present a rosy outlook for the housing market and inch a little bit further toward dangerous loan territory – but for the moment, let's consider the easing of the housing market good news.
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