Apr262016

Borrowers with stellar FICO scores rewarded with lower mortgage insurance rates

Lenders utilize FICO scores to evaluate the risk that a borrower will repay the debt as agreed. The lower the score, the higher the risk, so lenders charge higher rates for lower FICO score borrowers.

qualifedThe availability of credit cycles from periods of tight underwriting standards to periods of lax standards. Credit-fueled markets like real estate are most stable when credit is tight because very few borrowers default. In a tight credit environment, lenders are very focused on ensuring the borrower can repay the loan and the lender can recover their capital if the borrower fails to pay. It would seem obvious and intuitive that lenders would always be focused on those things, but history shows that when times are good, lenders often ignore the risks to compete for business.

When credit standards reach their tightest, the quality of loans underwritten is highest, and default rates are very low. Lenders know they turn away creditworthy customers (see: 85% of good borrowers with low FICO scores will never get a mortgage), so they search for areas where they can relax standards without causing delinquency rates to rise significantly and default losses to mount.

As the loosening cycle begins, lenders extend credit to less creditworthy borrowers, adding to the borrower pool, and in the case of real estate, it adds to the buyer pool. As new borrowers and buyers come to the real estate market, demand rises, and this new demand tends to push house prices higher. As prices rise, lenders feel lenders greater assurance they will recover their capital in the event one of these less creditworthy borrowers defaults. In fact, the entire subprime business model was built on this phenomenon.512px-Subprime_Mortgage_Offer

Subprime borrowers always defaulted at high rates, but as long as the inflow of new subprime borrowers was strong, prices would rise and subprime lenders would not lose much money when they foreclosed. In essence subprime lending is a Ponzi scheme because it only succeeds as long as prices are rising. Once prices stop rising, the high default rates cause huge losses which wipes these lenders out.

Once credit starts to contract, standards tighten until borrowers no longer default. If this were not the case, falling prices would cause large lender losses on the bad loans. Delinquency rates must fall to levels that are so low that lenders lose little or no money on the default. This is why down payment requirements and FICO scores go up during any disruption in the housing market.

Thus, at the bottom of the credit cycle, lenders extend credit to only the most creditworthy borrowers, and these borrowers are required to put substantial amounts down to protect the lender’s loan capital. That’s where we were four years ago. Over the last few years credit loosened up slowly as house prices stabilized and lenders perceived less risk of loss on their original capital: Lenders assume more risk, more borrowers enter the buyer pool, and the cycle starts all over again.

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Looking for a low-down-payment loan? If your FICO score is good, you’re in luck.

By Kenneth R. Harney, April 20, 2016

If you’re planning to buy a home with a low down payment, you need to be aware of some important but virtually unpublicized price changes underway in the mortgage market.

If you’ve got good but not great credit, such as a FICO score in the mid to upper 600s, you’re going to get hit with higher fees on a conventional (non-government) loan with a low down payment. Count on it. On the other hand, if you’re part of the credit elite — your FICO score is 760 or higher — congratulations: You’re in line for an unexpected discount on fees, despite making a tiny down payment.

Rep. Melvin Watt, D-N.C., a member of a House Judiciary subcommittee participates in a legislative hearing on H.R. 6101, the "Legal Services Corporation Improvement Act" on Capitol Hill, Tuesday, Sept. 26, 2006, in Washington. The board chairman, Atlanta attorney Frank Strickland of the federal legal aid service for the poor, despite secret transcripts to the contrary, denied to lawmakers Tuesday that some officials wanted to fire the internal watchdog who questioned directors' commitment to the anti-poverty mission. Strickland, said directors only discussed whether to conduct a performance review of Inspector General Kirt West and considered how to respond to what one board member called West's shoddy work. (AP Photo/Manuel Balce Ceneta)The GSEs evaluated the performance of loans they insured, and they repriced risk to appropriately match the risk profile of the borrowers. This is how underwriting is supposed to work.

I must admit, I am pleasantly surprised at what a good job Mel Watt has done at the helm of the FHFA, the government entity that controls the GSEs.

What’s going on? Put simply, the mortgage insurance premiums on loans eligible for sale to giant investors Fannie Mae and Freddie Mac underwent a shake-up this month. Applicants with lower scores and smaller down payments got whacked.

To illustrate: According to one mortgage insurer’s rate sheet, the buyer of a $400,000 house with a 660 FICO, a 3 percent down payment and a fixed rate of 4 1/8 percent would have paid $2,359 a month in principal, interest and mortgage insurance before the premium changes took effect April 4. Today, the same borrower would be charged $2,495 a month — $136 more a month, $1,632 more a year. But a borrower with a 760 FICO seeking the same size loan with a rate of 3 7/8 percent would now be charged $162 less per month — $2,002 vs. $2,164 — because of the pricing revisions. …

Those who are good credit risks are no longer subsidizing their deadbeat neighbors. For those who want to politicize this issue, the political left will hate this move.

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Mortgage insurers say they were forced to make the pricing revisions because Fannie and Freddie rejiggered capital requirements on them. “We had to end up charging more,” said Michael Zimmerman, a senior vice president at MGIC, a major insurer. The “cross-subsidization” in premium rates that previously existed — where borrowers with excellent credit were charged a little more in premiums so that lower-FICO borrowers could pay a little less — has “now been eliminated.” …

What do the new changes in insurance premiums mean to you in practical terms? If you’ve got a FICO score in the mid to upper 600s and you want to make as small a down payment as possible, you’ll probably want to look to the Federal Housing Administration for your financing.FHA offers 3.5 percent minimum down payments and is more flexible and lenient than Fannie and Freddie on credit issues and debt-to-income ratios. Last year, FHA slashed its own premiums, and they’re now the less-costly choice below 700 FICO.

But FHA-insured loans have a key drawback: Unlike private mortgage insurance, you generally can’t cancel premium payments once your equity reaches a certain threshold. So you could end up paying monthly premiums indefinitely. That’s a real turn-off.

loan_qualificationWhile keeping the insurance is a drawback, FHA loans also allow assumability, which is a big plus. (See: FHA financing and loan assumption (update))

Historically, credit standards loosen very slowly. Each incremental change that loosens standards requires time to evaluate its efficacy. Any lender who relaxed too many standards too far too soon would find itself on the losing end of a long stream of buybacks — or in the past, losses on its own portfolio. What really drives lenders to loosen credit is rapidly rising prices and large demand from investors to deploy capital in new loans.

Investor demand for 4% loans with 30-year amortizations has been surprisingly robust considering the general improvement in the economy and a higher federal funds rate. Ordinarily, investors would flee these safe-haven investments as less risky and higher yielding alternatives appear as the economy improves. So far, that hasn’t happened, and mortgage rates remain near record lows.

(See: We’ve reached a permanently low floor in mortgage interest rates)

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