FHA Mortgage Lending Practices
FHA mortgages by the Federal Housing Administration were created for the purpose of encouraging new construction as a means of creating jobs.
To accomplish this goal, the FHA offered to insure lenders against losses due to non-repayment when they made mortgage loans on both new and existing homes. In turn, the lender had to grant up to 20-year amortized loan terms and loan-to-value ratios of up to 80% rather than the 3- to 5-year, 50% to 60% term loans common up to that time. Lenders were at first skeptical regarding the change, but finally reasoned that, if the U.S. Government would insure against losses, they would make the loans.
Meanwhile, the FHA did its best to keep from becoming a continuous burden to the American taxpayer. When a prospective borrower approached a lender for an FHA-secured home loan, the FHA reviewed the borrower's income, expenses, assets, and debts. The objective was to determine if there was adequate room in the borrower's budget for the proposed loan payments. The FHA also sent inspectors to the property to make certain that it was of acceptable construction quality and to determine its fair market value. To offset losses that would still inevitably occur, the FHA charged the borrower an annual insurance fee of ½ of 1% of the balance owed on his loan. The FHA was immensely successful in its task. Not only did it create construction jobs, but it raised the level of housing quality in the nation and, in a pleasant surprise to taxpayers, actually returned annual profits to the U.S. Treasury. In response to its success, in 1946 Congress changed its status from temporary to permanent.
Current FHA Coverage
Although the FHA insures only a portion of the home loans in the United States (presently about one home loan in five is FHA insured), it has had a marked influence on lending policies and construction techniques throughout the real estate industry. Foremost among these is the widespread acceptance of the high loan-to-value, amortized loan. In the 1930s, lenders required FHA insurance before making 80% LTV loans. By the 1960s, lenders were readily making 80% LTV loans without FHA insurance. Meanwhile, the FHA insurance program was working so well that the FHA raised the portion it was willing to insure. By 1983, for a fee of ½ of 1% per year, the FHA offered to insure a lender for 97% of the first $25,000 of appraised value and 95% above that to a maximum loan of $90,000. To illustrate, on a $60,000 home the FHA would insure 97% of the first $25,000 and 95% of the remaining $35,000,for a total of $57,500. This means a cash down payment of only $2,500 for the buyer.
The borrower is not permitted to use a second mortgage to raise his down payment money. The FHA requires some down payment; otherwise, it is too easy for the borrower to walk away from his debt obligation and leave the FHA to pay the lender's insurance claim. A strong argument can be made that even if a buyer places 3% to 5% cash down he still owes more than he owns the moment he takes title. This is because it would cost about 6% in brokerage fees plus another 1% to 2% in closing costs to resell the home. Inflation in home prices since the 1940s has kept the FHA's insurance losses relatively low.
The FHA led the way in other respects. Once 20-year amortized mortgage loans were shown to be successful investments for lenders, loans without FHA insurance were made for 20 years. Later, when the FHA successfully went to 30 years, non-FHA-insured loans followed. The FHA also established loan application review techniques that have been widely accepted and copied throughout the real estate industry. The biggest step in this direction was to analyze a borrower's loan application in terms of his earning power. Prior to 1933, emphasis had been placed on how large the borrower's assets were, a measurement that tended to exclude all but the already financially well-to-do from home ownership. Since 1933, the emphasis has shifted primarily to the borrower's ability to meet monthly PITI payments. The rule of thumb today is that no more than 38% of a person's gross monthly income should go to the repayment of fixed monthly obligations including monthly PITI payments.
The FHA has also been very influential in improving construction techniques. When the property for which FHA insurance is requested is of new construction, the FHA imposes minimum construction requirements regarding the quantity and quality of materials to be used. Lot size, street access, landscaping, and general house design must also fall within the broad guidelines set by the FHA. During construction, an FHA inspector comes to the property several times to check if the work is being done correctly. A home that was not FHA inspected during construction can still qualify for an FHA-insured loan if it has been occupied for 1 year and meets certain FHA requirements.
The establishment of construction standards is a two-edged sword. The FHA recognizes that if a building is defective either from a design or construction standpoint, the borrower is more likely to default on his loan and create an insurance claim against the FHA. Furthermore, the same defects will lower the price the property will bring at its foreclosure sale, thus increasing losses to the FHA. An important side effect has been to establish certain national standards in housing construction that have raised the quality of construction in regions where FHA standards are more stringent than local building codes.
Other FHA Programs
Thus far, our discussion of the FHA has centered on insuring home mortgage loans under Section 203(b) of Title II of the National Housing Act. This FHA program has insured over 11 million home loans and is the program for which the FHA is most widely known. However, the FHA administers a number of other real estate programs. Several of the better known programs will be briefly discussed.
Under Title I of the National Housing Act, the FHA will insure lenders against losses on home mortgage loans made to finance repairs, improvements, alterations, or conversions of existing residences. Under Title II, Section 207 provides for insuring mortgage loans on rental housing projects of eight or more family units and on mobile home parks. Section 213 provides for insuring mortgages on cooperative housing projects of eight or more family units. Section 220 insures financing used to rehabilitate salvageable housing and to replace slums with new housing. Section 221(d)(2) operates similarly to 203(b), but permits 100% insured financing for low- and moderate-income family housing. Section 221(d)(3) provides mortgage insurance to finance nonprofit rental and cooperative multifamily housing for low- and moderate-income households. Under Section 223(e), the FHA insures mortgages used to purchase or rehabilitate housing in older, declining urban areas. Section 223(f) offers mortgage insurance to purchase or refinance existing multifamily rental housing. Under Section 234, the FHA insures individual housing units in a multifamily building of five or more units operated on a condominium basis.
Section 235 offers single-family residence interest subsidy program. However, Section 236 which subsidized owners of low-rent apartment buildings has not been reactivated since it was suspended in 1973. As an alternative the FHA now administers a Title II, Section 8 housing assistance program. Under this program, low- and moderate=income families, including single, elderly, disabled, or handicapped persons, can obtain FHA certificates that permit them to negotiate for suitable rental dwelling. Aided families then contribute between 15% and 25% of their total family income to the dwelling unit's rent. The difference between that amount and the actual rent is subsidized by the U.S. Government through the Department of Housing and Urban Development (HUD).
Section 237 deals with special credit risks. A low- or moderate-income applicant with a poor credit history must agree to accept budget advice and debt counseling before the FHA will insure his or her home mortgage loan. Under Section 245, FHA mortgage insurance is available for graduated payment mortgages. This mortgage format allows the borrower to make smaller payments initially and to increase their size gradually over time. The idea is to parallel the borrower's rising earning capacity.
In addition to the above FHA programs, the FHA offers mortgage insurance on rental projects on or near military bases, land purchases for new town developments, nursing homes, hospitals, mobile homes, mobile home parks, and college housing.
FHA Mortgage Programs To VA Programs