FHA Reform Bill to Allow Smaller Down Payments, Higher Fees

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The Federal Housing Administration reform bill overwhelmingly approved in the U.S. House of Representatives last Thursday will strengthen the housing finance agency, but will likely prove to be mixed blessing for homebuyers.

The legislation, passed by a vote of 406 to 4, would raise fees for borrowers, give the FHA the power to oust lenders that are costing the agency too much money in claims, and make it easier for the FHA to protect itself from fraud-related losses. On the positive side, it will also allow borrowers to get mortgages with smaller down payments.

The primary purpose of the reform legislation – introduced by Rep. Maxine Waters (D-Calif.) – was to shore up the deteriorating finances of the FHA, an agency whose prominence in the mortgage business has skyrocketed lately.

The FHA doesn't make home loans; instead, it insures lenders against default. Less than four years ago, it was handling only 4 percent of home loan volume. Today, the agency insures roughly one-third of all new mortgages in the U.S.

Last year, however, the FHA reported that its reserves had fallen to just $3.6 billion as of Sept. 30. That represented a scant 0.53 percent of the $685 billion worth of FHA-insured loans at that time. By law, the reserves in FHA's Mutual Mortgage Insurance Fund must be at least 2 percent of all FHA loans.

So the House bill will bolster the FHA's capital by allowing agency to nearly triple the caps on annual mortgage insurance premiums it charges to 1.50 percent from 0.55 percent of a mortgage. Those premiums are paid by borrowers over the life of their home loans. The FHA says the premium increase will cost the average borrower about $42 a month.

For borrowers, the tradeoff for paying higher fees is that homebuyers will have more ready access to credit and can get mortgages with smaller down payments of just 3.5 percent, versus the 5 percent to 20 percent down payments typically required by conventional mortgage lenders.

Industry groups applauded the move, saying it will safeguard the FHA and help it continue its role of providing affordable housing to low-to-moderate-income Americans.

"We hope the Senate will be empowered by the House action and will consider similar legislation quickly," said Robert Story, chairman of the Mortgage Bankers Association.

No companion legislation on FHA reform has been introduced yet in the Senate. But it's expected to take up the matter after the July 4 recess.

Several Amendments Defeated

In many ways, the House version on FHA reform is as notable for what was not included in the bill, as for what did make it into the final legislation.

In passing the FHA legislation, the House defeated three other hotly-debated proposals:
  • A proposal to raise down payments on FHA loans to 5 percent from 3.5 percent.
  • An amendment by Republicans to scale back by 2012 the FHA's market share to 10 percent of all newly originated mortgages.
  • An amendment to lower FHA loan limits, which are now as high as $729,750 in high-cost areas of the country.
It was the proposal to raise down-payment requirements, though, that was the most contentious. The amendment was introduced by Rep. Scott Garrett (R-N.J.), who had argued that bigger down payments would promote responsible, sustainable homeownership by making borrowers more committed to their mortgages and less likely to walk away from underwater homes.

Garrett wasn't the member of Congress to first to try to push through the idea of larger down payments for FHA loans. Multiple attempts in the Senate by Sen. Richard Shelby to increase the FHA minimum down payment to 5 percent also have failed.

The Mortgage Bankers Association, the National Association of Home Builders and the National Association of Realtors all supported efforts to keep down payment requirements at 3.5 percent.

"The current 3.5 percent down payment represents a significant financial commitment and sufficient investment to insure a borrower's seriousness about homeownership," said NAR President Vicki Cox Golder.

She added that raising down payment requirements would "have an especially harsh impact on African American and Hispanic borrowers, who traditionally have much lower accumulated wealth and have benefited from the opportunities offered by fully documented, standard FHA loans with low down payments."

In 2009, the FHA was by far the largest source of financing for minority borrowers, insuring 52% of all loans made to African-American homebuyers and 45% of mortgages to Hispanics.

A Compromise on the Down Payment Issue

Ultimately, the prospect of raising down payment requirements at the current time appeared to be unpalatable politically and economically. Such a move before a midterm election could have proved unpopular with voters. Moreover, toughening mortgage requirements for borrowers – by demanding bigger down payments – runs contrary to the federal government's efforts to help bolster the U.S. housing market.

President Barack Obama and his advisers, who have struggled to come up with effective widespread solutions to the country's housing and foreclosure problems, explicitly opposed the idea of raising down payment requirements.

FHA Commissioner David Stevens told a House Financial Services panel in March that the Obama administration "determined after extensive evaluation that such a proposal would adversely impact the housing market recovery."

By the FHA's own analysis, raising the down payment requirements would have precluded some 300,000 borrowers from buying a home and added just $500 million to the FHA's coffers. By comparison, other FHA changes, including raising fees on borrowers, would generate some $4.1 billion.

Nevertheless, the issue of forcing home borrowers to make larger down payments, and have "more skin" in the game won't be going away any time soon. Indeed, lawmakers struck a bit a a compromise on this topic in passing FHA reform.

One provision successfully injected into the House reform bill requires the agency to examine down payment requirements annually and submit yearly reports to Congress on the matter.

So even though borrowers may still be able to secure low down payment FHA mortgages now, there's certainly no guarantee that FHA requirements won't be toughened in the future. So, prospective home buyers considering FHA loans in 2011 and beyond should position themselves for the possibility of having to make bigger down payments.

Future Givebacks to Borrowers?

FHA's health is critical not to just borrowers who get FHA-insured loans, but to the entire housing market and taxpayers everywhere.

FHA's market share, combined with loans backed by Fannie Mae and Freddie Mac, means that the government now directly or indirectly backs more than 95 percent of the U.S. mortgage market. Without a fix to FHA's financial woes, observers feared that the agency might have to receive a government bailout – as did Fannie and Freddie, which were seized by federal regulators in 2008.

Coming up with a down payment has historically been the biggest impediment to becoming a first-time homebuyer. So it's no surprise that many prospective mortgage borrowers have been flocking to FHA loans amid the credit crunch.

The reform legislation – if passed by the Senate as well – may hold out one other attraction for FHA borrowers. The FHA says if it ultimately wins the power to raise annual premiums, it will lower another charge imposed on borrowers: an upfront premium, which is now 2.25 percent. The FHA plans to slash that premium to just 1 percent.

Want to learn more about the state of home mortgages and your personal finance concerns? Get more of Lynnette Khalfani-Cox's insights on home finance at the upcoming panel "What Works Now: Smart Moves When Buying a Home," created by AOL Real Estate in partnership with Bank of America Home Loans and broadcast on AOL June 23. Sign up at realestate.aol.com/home-buying-answers to get an e-mail reminder of the event.
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