The FHA (Federal Housing Administration) is preparing to make some changes to their requirements for home buyers and the mortgages they essentially guarantee.

Because of recent default rates — people not paying their mortgages — on FHA backed mortgages (as well as mortgages, in general), the reserves have fallen way below those mandated by Congress and if not replenished, the FHA may require a taxpayer bailout along the lines of the rest of the financial services industry. This is not a good thing.  So, in order to shore up their reserves, the FHA is making some changes:

• initial or “upfront” payment of the mortgage insurance required will jump from 1.75% to 2.25% of the loan value. Depending on the amount of the loan, this jump could be significant.  However, the FHA is considering spreading this out into an annual fee over the life of the mortgage.  This will ease the pain a little and it will also increase the monthly mortgage payment.
• reduce the amount the home seller can contribute to the home buyer’s closing costs from 6% to 3%. Typically, moderate income home buyers have very little cash reserves to purchase a house.  Down Payment Assistance programs have gone away so it is now mandatory that the home buyer produce the 3.5% needed for the minimum down payment. Closing costs — things like lender fees, title company fees, transfer and recordation fees required by State and County governments — may add up to as much as 5% of the sales price of the home.  Add in any points the home seller may want to pay on the home buyer’s behalf and it’s easy to get to 6%.  Now, it looks like the home buyer is going to have to come up with some additional cash.
• an increase in the down payment requirement from 3.5% to 10% for low credit score borrowers.  It can be argued that folks with credit scores of 580 and below are extremely high risk borrowers who would be the first to walk away from a home in times of economic distress.  There may be some mitigating circumstances such as an illness or a messy divorce.  However, if someone has a score below 620 it may be worthwhile to require a higher down payment.

More Skin in the Game

All of these changes including another down payment requirement, this one from 3.5% to 5% for everyone, is all in the name of forcing home buyers to have “more skin in the game”.  The thinking is that during the early go-go 2000s many home buyers bought homes they couldn’t afford with very little or no money of their own.  They didn’t appreciate the true consequences of the mortgages and the obligation to repay the mortgage.  As a result, when things got tough, they just walked away.  No loss.  No big deal.

Since FHA backs a lot of mortgages, they ended up paying the banks for the bad loans.  The more mortgages that went south, the more money that came out of FHA reserves.  Now, it’s time to pay the piper.

Good News, Bad News

The good news, from my point of view, is that these new requirements will require more responsible lending practices. It will also cause home buyers to be more responsible with their credit and encourage them to save more for what will be the largest purchase in their lives.

The bad news is that it will shrink the pool of home buyers, especially in the moderate income area.  Home prices may have to decrease more in order to attract home buyers that will now need more cash to make a home purchase.  After all, these changes are all percentages of the mortgage amount which is related to the sales price of the home.  It’s like a row of dominoes.  When one thing changes, everything else in it’s path changes, too.

The bottom line is that selling and buyer a home is getting more difficult. If there was any remote fantasy of going back to the days of rapid price appreciation or being able to sell your home in a week, these changes by the FHA will banish that fantasy forever.

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