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The New World of Mortgage ‘Buffers’

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There’s a great curiosity in the real estate marketplace: interest rates are low while home values have yet to reach the prices seen in 2007 and yet borrowers are having trouble getting loans.

This seems like a strange paradox given the huge backlog of would-be buyers who might be expected to look for homes. And the picture gets even odder when one considers that low rates should equal more affordability.

In the past increasing home equity might have spurred buyers to make the plunge into real estate ownership, the logic being that you wanted to buy now before prices rose any further.

Falling Incomes
But now the barrier to entry is not so much rising home prices but falling incomes. Households today simply have less money than in the past — the Census Bureau says household income was 9 percent lower in 2012 than it was in 1999. That’s an anchor which plainly holds back real estate price increases in most markets.

It’s not just an issue of less income, there is also the problem of tuition costs. A new report from the Federal Reserve shows that student loans amounted to $832 billion in 2009 and reached $1.226 trillion at the end of 2013.

That’s a student loan increase of 47 percent and you have to wonder what America is getting for its money. Are we 47 percent brighter? Forty-seven percent better educated?

The problem with the huge growth  of student debt is that it comes at the very time Wall Street reform rules have kicked in. Most real estate loans today are "qualified mortgages," a form of finance greatly favored under the Dodd-Frank legislation because it represents little risk to borrowers or lenders.

Debt-To-Income
There are a number of standards which lenders must meet to create qualified mortgages and one of the most important concerns debt: The general rule is that recurring debt cannot exceed 43 percent of an individual’s income. This is the debt-to-income ratio or DTI.

If a household has a monthly income of $7,000 then as much as $3,010 (43 percent) can be used for housing costs such as mortgage payments, property taxes and property insurance as well  as monthly expenses including auto debt, credit bills and student loans.

If student debt has grown enormously in the past few years it means there is less room for other obligations under the 43 percent debt limit — including housing costs.

The relationship between bigger student debts and a reduced capacity to qualify for a mortgage loan of a certain size is fairly clear. The catch is that the 43 percent LTV cap is only a part of the problem.

Lenders for very good reasons do  not want to violate any part of Dodd-Frank nor any agreement with mortgage investors. Sell a loan to an investor which does not meet required standards and the lender can face big sanctions — including, in some cases, an enforceable demand to buy back to the loan.

Notice that already lenders have made settlements worth more than $100 billion to resolve claims that loans made before the mortgage meltdown did not meet promised representations and  warranties.

Meet the ‘Buffers’
The result is that many lenders are willing to make loans with a 43 percent DTI ratio — and many are not. To be on the safe side such lenders adhere to “buffers,” meaning that maybe they’ll make a loan which allows a borrower only a 42 percent DTI. Or 41 percent.

According to the National Association of Realtors nearly half of all lenders — 47 percent — now employ DTI buffers. NAR also reports that some lenders also have a second buffer, this one concerning interest rates.

Under Wall Street reform lenders are presumed to have originated a qualifying mortgage if the interest rate is not more than 1.5 percent above the APOR — the Average Prime Offer Rate — an index created and run by the government.

Once again, reports NAR, some  lenders are insisting on a pricing buffer to assure that they do not breach the magical 1.5 percent standard. How many? A full 40 percent of the lenders polled.

It might seem as though a little off the interest rate is not a bad idea from a borrower’s perspective, but lenders are in business to make a profit just like everyone else. A lower interest rate might translate into a reduced willingness to originate loans except for a fortunate few with sterling credit and a good relationship with the lender.

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