The Los Angeles Times reported last week that Fannie Mae and Freddie Mac have come up with a new set of looser standards for lenders, designed to make mortgages accessible and affordable to prospective homebuyers who don't have perfect credit.
Will this have the desired effect of boosting home sales? After all, loans with low down payment requirements are already available to low-credit borrowers through the Federal Housing Administration, or FHA. Also, isn't it true that easy mortgages caused the mortgage crisis in the first place?
What the new guidelines mean to buyers
According to the report, the new guidelines are intended to be much clearer than those that now exist, so lenders can feel comfortable approving mortgages for lower-credit borrowers.
If Fannie and Freddie determine a bank violated its guidelines when making a loan, they can demand the bank repurchase it, effectively putting all the risk on the bank. Since the guidelines have been relatively unclear in the recent past, banks have erred on the side of caution. For example, the current guidelines require a minimum credit score of 620, but this year's average score for an approved loan is 742, well into the realm of "excellent" credit.
The official guidelines are yet to be released, but the report indicated that the minimum down payment requirement will drop from 5% to 3% of the purchase price.
Not much else is likely to change with the numerical guidelines themselves. After all, a 620 credit score and a low down payment are already pretty loose requirements. However, the point of these changes will be to more clearly define who is qualified for a loan and when the banks will be at risk of repurchase demands.
What about FHA loans?
Federal Housing Administration loans have been around for years, offering buyers with low credit scores (even below 600) the opportunity to buy a house with a down payment as low as 3.5%.
The problem with FHA loans is that they are expensive, and they seem to keep getting increasingly costly as time goes on. If you put less than 20% down, you're required to have FHA mortgage insurance, which costs 1.75% of the loan amount up front, and up to 1.35% of the remaining loan balance every year. And thanks to one of the recent increases, borrowers who put less than 10% down have to pay mortgage insurance for the life of the loan.
To put this in perspective, let's say you buy a $250,000 house with an FHA mortgage, and that you put the minimum amount down, or $8,750 (3.5% of the purchase price). That means the up-front mortgage insurance premium will add more than $4,200 to your closing costs. And your annual mortgage insurance premium will cost about $3,250, adding roughly $270 to each monthly mortgage payment.
You'll need mortgage insurance for a low down payment conventional loan as well, but the cost is usually much less than the government's version. You might not have to pay an up-front premium, and the annual rate generally ranges from 0.3% to 1.15% of the loan amount.
The biggest difference is that with a conventional loan, you can drop the mortgage insurance once your loan-to-value ratio hits 80%. This alone can save you tens of thousands of dollars over an FHA loan.
As long as it's done right, we have nothing to worry about
Critics of the new guidelines argue that looser lending standards could lead to another housing bubble and subsequent crisis. However, no matter how loose lending standards get, there is one key difference: documentation.
As long as lenders are required to thoroughly document borrowers' income, assets, and other qualifications, the risk remains relatively low. As we know, during the mid-2000s' lending bubble banks regularly would simply take the borrowers' word regarding income and other qualifications.
Plus, even with the lower down payment requirements, it's unlikely that borderline candidates in terms of credit and income will qualify for a conventional loan with 3% down anytime soon. The report said "mortgages with down payments of as little as 3% for some borrowers," so until details become known when the official guidelines are released, it sounds like the lowest down payments will still only be available to those borrowers with the highest credit scores.
Subprime lending definitely has a place in a healthy real estate market -- as long as it is done right. Hopefully this will give the real estate market a nice boost during the coming months.
