“What type of borrower finds it advantageous to take an FHA loan?”

The answer to this question is a little different today than in 2000 when I first addressed it because FHA’s market niche is smaller. This reflects developments in the conventional sector that have not been matched by FHA, including the growth in popularity of loans with no down payment, interest-only monthly payments, and option ARMs. Reflecting these developments, FHA’s market share fell from about 15 percent in 2000 to about 5 percent in 2006.

The FHA Market Niche in 2006. An FHA borrower:

  • Has blemished credit acceptable to FHA, but not strong enough for prime pricing in the conventional market.

  • Doesn’t need a loan larger than the FHA maximum, which varies by county. (In 2006, it ranged from $200,160 to $362,790 in the highest-cost counties.)

  • Can put 3 percent down in cash.

  • Doesn’t want an interest-only mortgage or an option ARM.

Credit Requirements: At risk of oversimplifying, credit standards in the conventional market range from A+ to D-, and within that range, FHA would be about B- or C+.

FHA credit requirements overlap the higher levels of subprime requirements. A good illustration is the underwriting rules applicable to a prior foreclosure. With exceptions, FHA won’t accept a loan applicant who has had a foreclosure within the prior three years. Subprime lenders may have a three-year rule for their best credit grade, but the period scales down by degrees and might be only one year for the lowest grade.

Similarly, the maximum ratio of total debt service to income acceptable to FHA is 41 percent, which is generally high relative to prime standards, but well below what passes in the nonprime sector.

A borrower who meets FHA credit standards will usually do better with an FHA loan than with a subprime loan, despite having to pay a mortgage insurance premium. The rate will be lower, the borrower will have access to a large menu of mortgages, and there are no prepayment penalties. Most mortgages in the subprime market are 2-year adjustables with large margins, which means a high probability of a rate increase after two years, and they have prepayment penalties, usually for three years.

Loan Limits: The loan limits on FHAs are a major deterrent. HUD has asked Congress to allow the same loan amounts on FHAs as on loans purchased by Freddie Mac and Fannie Mae. In 2006, this would have meant an increase to $417,000 uniform across the country.

Down Payment Requirements: In 2000, FHA’s 3 percent down payment compared with 5 percent on most conventional loan programs. In 2006, however, zero-down loans were widely available in the conventional sector, while the FHA minimum of 3 percent remained unchanged. Since zero-down loans have long been available under the VA program, FHA is now the only sector that does not have them.

This disadvantage of FHA is partially offset by down-payment-assistance programs available to FHA borrowers. One form of such assistance is second mortgages at preferential rates, which is the preferred method of public agencies at the city, county or state levels. These agencies have their own eligibility rules independent of FHA.

A second form of assistance is cash contributions from nonprofit corporations. These have no repayment obligation, but the funds provided come from home sellers who take account of the contribution in setting their sales prices.

Neither type of assistance is a good substitute for a zero-down program, a bill for which was introduced in Congress in 2004. So far, however, it has not been passed.

Interest-Only Mortgages and Option ARMs. These instruments exploded in popularity after 2000, but were not available under FHA and there is little likelihood that they ever will.

Prospects For a Revival in FHA’s Market Share. Congressional authorization of no-down-payment loans and a rise in loan limits would increase FHA’s market share. So would an increase in public awareness that some subprime borrowers would qualify for, and do better with FHA loans.

A marked increase in FHA’s market share would result from an explosion in foreclosures, which would cause a drastic restriction of lending terms in the conventional sector. This is not something I would care to see, but if it happened we will be pleased that FHA was there to help cushion the blow.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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