Improving Default Rates

From 7/24/14
Improving Default Rates on F.H.A. Loans

Default rates for loans backed by the Federal Housing Administration have consistently been higher than those on loans guaranteed by the Department of Veterans Affairs. New research from the Urban Institute suggests that a key difference in how the programs measure a borrower’s ability to pay could account for much of this performance gap.

Both government-backed programs are critical to first-time and lower-income home buyers because they allow minimum down payments. F.H.A. borrowers can put down as little as 3.5 percent of the loan amount, while the V.A., which is limited to veterans and active-duty military personnel, allows for 100 percent financing.

Institute researchers compared F.H.A. and V.A. performance for mortgages originated in 2000 through 2012, and found the cumulative default rate over the life of the loans to date has been consistently higher for F.H.A. loans in each of the years, with the gap widening from 2005 to mid-2007.

For the 2007 origination year, for example, the worst for F.H.A., 36 percent of loans have gone at least 90 days delinquent. By contrast, the default rate for VA loans from that year was 16 percent.

Even when the researchers looked at loans from borrowers with similar income, credit scores and mortgage burden, V.A. loans still performed better.

The study points to two structural differences that could account for the V.A.’s performance. One is the level of lender responsibility. V.A. loans are guaranteed for a maximum of 25 percent of the loan amount; F.H.A. loans come with a 100-percent guarantee. The other difference involves underwriting. In addition to measuring the debt-to-income ratio, the V.A. uses a “residual income” test. Borrowers must show a certain level of income after the mortgage payment, taxes, utilities and job-related expenses (like child care) are subtracted from gross monthly income.

The minimum residual income levels are set by family size and region. In the Northeast, on loan amounts of $80,000 or more, a household of two must show at least $755 in monthly residual income; for four, the minimum is $1,025.

“We think residual income is probably more important than risk sharing,” said Laurie Goodman, the director of the Urban Institute’s housing finance policy center, “but it is actually extremely difficult to disentangle it.”

She estimated that F.H.A. could potentially cut defaults by as much as 20 percent if it incorporated the residual income test. Using the debt-to-income ratio alone doesn’t really measure whether a borrower will have enough excess income to cover living expenses, she added.

This can be a critical difference for lower-income borrowers. For example, two borrowers could each show a mortgage debt load of 40 percent of income, but the one with an income of $60,000 will have substantially more money left each month to cover living expenses than the one with an income of $30,000.

Geoffry Walsh, a staff attorney at the National Consumer Law Center, noted that in January, HUD adopted a new F.H.A. guideline that allows lenders to use the residual income formula as an alternative way to qualify borrowers who exceed the standard debt-to-income threshold.

But Ms. Goodman says using the formula in that fashion does not screen out marginal borrowers; instead it allows higher-income borrowers to buy costlier homes than they could otherwise qualify for.

Richard Morris, the vice president of investor relations and equity lending for Navy Federal Credit Union, which did $5.7 billion in V.A. loans last year, said the lower default rate is also attributable to the tendency of military borrowers to “take their financial obligations very seriously.”

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