Here’s a quick and easy way to sell more houses and raise real estate values: Just reduce credit requirements for mortgages and the whole country will be on its way to a housing rebirth of unprecedented size and power.
This is exactly the point made by Sen. Elizabeth Warren (D-MA) at the Senate Banking, Housing and Urban Affairs Committee hearing to consider San Antonio Mayor Julian Castro as the next HUD secretary. Warren points out that in 2011 the typical conventional borrower had a credit score of 711 but by 2013 the usual credit score for conventional loans had risen to 756. That’s a big difference; one which Warren says excludes 50 million potential borrowers from buying a home.
If 50 million additional buyers were added to the mix there’s no doubt that real estate sales would be booming and with it much of the economy. That said, there are a number of reasons to believe that even if Fannie Mae, Freddie Mac and the FHA were suddenly to announce softer credit standards the impact would be far less than Sen. Warren suggests.
To begin with loans with lower credit requirements are plainly available. Under current HUD requirements, borrowers can get an FHA loan with 3.5 percent down if they have a credit score of at least 580. In fact, borrowers with 10 percent down can get FHA financing with a credit score of as little as 500, a credit score deep into subprime territory.
The ability of lenders to make FHA loans on the basis of minimal credit scores plainly exists. No new standards, policies or legislation is needed. Today, right now, any FHA-qualified lender can offer financing to individuals with seriously-impaired credit, individuals with a credit score of less than 580.
Yet almost no FHA loans are made to borrowers with such minimal credit standings, despite the yammerings of critics who attempt to link FHA financing with subprime lending. According to HUD’s 2013 annual report to Congress, at the end of 2013 just 0.17 percent of all FHA loans went to borrowers with credit scores below 580. Moving up the scale, a measly 2.07 percent of all FHA mortgages were originated for borrowers with credit scores between 580 and 619.
Layering and Buffering
The real issue here concerns a practice called “layering” or “buffering.” One reason borrowers with woeful credit cannot get mortgages is because loan originators look at lending standards and then — to assure they meet all guidelines — bump up requirements. You can’t blame lenders for doing this because if a VA, conventional or portfolio loan goes bad they may have to eat some of the loss. If they have violated underwriting guidelines they can be forced to buy back the loan and maybe face costly litigation as well.
Layering is perfectly reasonable for all loan programs except FHA mortgages. The reason is that the FHA provides a 100-percent guarantee to lenders so if the loan fails the loan originator has no losses.
As an example of layering, consider that “qualified mortgages” under Wall Street reform cannot generally have a debt-to-income ratio (DTI) which exceeds 43 percent of the borrower’s income. In other words, if a household earns $8,000 a month then not more than $3,440 can be devoted to required monthly costs such as car payments, student loans and housing costs.
However, the National Association of Realtors reports that more than 30 percent of all lenders actually have stiffer requirements, say 42 percent, 41 percent and even 40 percent. If the maximum DTI is 41 percent then a household that takes in $8,000 a month cannot have required monthly payments which exceed $3,280. A tighter DTI means some borrowers will not qualify for financing or will have to accept smaller loans.
Figures from Ellie Mae show that the average closed loan had a credit score of 727 in May versus 749 in January 2013. However, Ellie Mae also reports that credit scores are substantially lower for FHA and VA loans.
There are three conclusions one reaches from this information.
First, financing is plainly available for those with less-than pristine credit scores.
Second, because of layering and buffering a reduction in formal credit score standards is unlikely to have much marketplace impact. In effect, we’re already there.
Third, the reason for limited loan activity involves rates more than credit scores.
While conventional loans may have high credit standards as Sen. Warren correctly points out, conventional financing is only part of the mortgage marketplace. There are other loan choices out there right now which are both financially attractive and readily available. FHA loans represent more than 20 percent of all the loans now being originated and VA financing is available to those with qualifying service. That’s a huge number of loan options which do not require gold-plated credit scores.
The central reason it’s tough for marginal borrowers to get a loan today is not the myth of high credit score requirements but because there’s not much incentive for lenders to offer fixed-rate loans for 30 years. Mortgage rates today are floating around 4.25 percent and are likely to trend higher, so why should lenders lock-in their money over the long term at low rates? Instead, the smarter alternative might be to wait until rates increase and lenders can get better returns. That’s the real reason why some $2 trillion in excess, “unloaned” cash now rests in lender vaults.