I know I sometimes harp on those good old days before the Great Recession came and crushed the hopes and dreams of millions of Americans, but when I read this news story in the Boston Herald, I couldn’t believe my eyes. Apparently, the difficult loan qualifications of years past are over and those of you who have been struggling to get a mortgage after paying your dues are going to get a second chance.
So, first, let’s talk about this new development and then we’ll dissect the pros and cons of it all. Opening lending to lower FICO borrowers is going to be a game changer for pretty much everyone who owns a home, has a mortgage or wants to get involved with either.
The Double Edged Sword of Low FICO Lending
Buyers with low FICO scores have long been a permitted part of FHA lending, but one that most lenders have ignored for a variety of reasons, including additional mortgage overlays and penalties from funding sources and governing bodies like FHA and Fannie Mae for making too many loans with a higher than average risk of default. So, traditionally, unless you have a really good story, your lender will automatically reject you for these types of programs with a score under 620.
When I say a “good story,” I mean a really good story. For example, if your credit score was in the high 700s and you were involved in a serious car accident that left you hospitalized for months and unable to work, resulting in a whole lot of late pays and collections, you might have a good story — provided that the whole mess leading to your 550 can be documented and you’ve made all your payments since then.
Most lenders won’t risk it, though. At least, they haven’t since before the real estate collapse — until last month.
The reason FHA lenders are going to start lending to those of you who are still rebuilding your credit is that the government has finally recognized that there are a number of alcoves of buyers who aren’t particularly risky, but happen to all be lower on the FICO food chain. The banks that cater to young first time homebuyers, minorities and working class families are finally getting a break and being recognized for the work they’re doing despite the risks.
According to the revised FHA Single Family Housing Policy Handbook, a bank that has been granted an exemption from the old “risky loan” rule will be allowed to write more loans for low FICO score borrowers that show promise and fit within tight income to debt guidelines. This is good news for you borrowers who are on the cusp, have decent cash reserves and are ready to restart your lives where you left off when the economy crashed and burned your plans.
At one time, FHA was not only the first choice of buyers who were cash poor, but also the refuge of low FICO buyers — it was a good alternative to subprime lending. It looks like FHA is trying to reclaim their former position in the mortgage hierarchy as a friend to the downtrodden. When you add this low FICO news to their already low downpayment requirements, FHA may well do it, too.
The Good, The Bad and The Ugly of FHA Low FICO Lending
Low FICO FHA lending will more than likely prove itself to be a double-edged sword for the mortgage industry. On one hand, there’s the potential for a lot of people who want to own their own home to get back into the market, on the other, the risk of default will rise as well. I see a number of pros and cons over the long term, some that worry me considerably.
Advantages to Low FICO FHA Lending
A lot of good can come from Low FICO FHA lending, if buyers are fully prepared for the responsibility of maintaining a mortgage. Here are some of the biggest ones I see coming:
Second chances for people hurt by recession. There’s no doubt that the recession hurt a lot of people really badly in a long-lasting way. Losing a house because your job just suddenly isn’t there is a great way to destroy your FICO score and your ability to get a loan. For these folks, a chance to secure a new mortgage and buy a new home will be a huge boon. Low FICO FHA will open the market back up to them in a way that’s safe from predatory lenders.
Lower FICO loans mean more loans overall. When banks are allowed to lend to lower FICOs, they’re going to make more loans. It’s not a hard trend to foresee — more loans mean more buyers, more sellers and more churn in the real estate market. This is a very good thing for the overall health of the market. Increasing market activity can be extremely beneficial to help smooth out economic bumps and make it easier to find comps for homes that go under contract.
Potential fast track to recover upside down housing values. Housing prices have been struggling to get out of the post-bubble slump since 2012, when they finally increased for the first time since 2006. This was great news, but in a lot of areas the gains have been slow and hard-earned. Slow is good for the general economy, but when you’re talking about prices that have dropped like they did in 2006, slow means you’re left with a lot of homeowners who are even now struggling with underwater mortgages.
Opening up FHA to more buyers may help to stimulate prices enough to get these homeowners back into the market, whether they’re selling, buying or simply refinancing. Getting them out of those higher interest mortgages will also free up cash in their wallets every month, so they can spend more on other things that help our economy grow. Housing prices will go up some, but I don’t think the small influx of buyers this program represents is guaranteed to cause a second bubble.
Faster credit recovery for buyers who couldn’t qualify before. Those of you who had your FICO scores vaporized by losing a home to a bubble-created foreclosure are probably still trying to dig out. A home mortgage is one of the rare credit trade lines that’s a lot more than it appears — and having one and paying it faithfully can help you recover your credit faster than a secured credit card or a student loan payment ever could. Better credit for more people living in a credit-driven economy is a really good thing for all of us!
The Downside of FHA’s Low FICO Lending
Although FHA’s opening of low FICO lending promises to help a lot of people, let’s not assume it’s going to fix everything. There are definitely some risks we take as a country with this new program — and if all the pieces don’t fall into place at the right time, it could cause some problems. Keep these risks in mind:
More buyers means higher prices if inventory remains limited. 2015’s housing inventory has been much lower than that of years past. This may be due, in part, to the fact that as much as 15 percent of all homes with a mortgage are still underwater. Regardless of the reason, it’s troubling that existing home inventory dropped by 14.3 percent year over year in June 2015. If this trend continues, the market balance will be really out of whack, with a lot of buyers and not a lot of sellers — which spells bidding wars and dramatically higher housing prices for you, especially if the lower FHA FICO requirements allow a lot more buyers than expected into the already competitive marketplace.
Rates will undoubtedly rise. The Federal Reserve has been chomping at the bit to raise rates for some time now, and if this loosening of FHA requirements stimulates a lot of buying, they may jump at the opportunity. They didn’t opt to raise rates this year, but it is coming — these low rates can’t last forever, especially if the market starts to show signs of improvement.
Risk of second real estate bubble. In a world where the interest rates are insanely low, mortgages are easier to get and prices are being pushed dramatically upward because of a lack of supply, the risk of a second real estate bubble is very, very real. We have to trust that FHA is carefully metering out these new low FICO loans because otherwise the feeding frenzy could be intense and much like what we saw in the mid 2000s.
The Bottom Line: Just Because You Can Doesn’t Always Mean You Should
I know I spelled out all the doom scenarios in the con column of FHA’s new low FICO lending products, but I think — I hope — it won’t come to that. I’ve long known FHA to be a fairly reasonable program, administered by fairly reasonable people. I’m sure they’re opening their doors to more buyers for the express purpose for stimulating the market, but not too much.
That being said, if you now qualify for an FHA loan under the new guidelines, I caution you to make doubly sure you’re ready to jump back into the market before securing a loan. Remember that buying a house is more than just buying a payment — you also get all the maintenance, repairs and expenses that go along with it.
If you’re ready to take on an unexpectedly leaky roof or a furnace that has to be replaced in the middle of winter, I wish you all the luck in the world of finding the home of your dreams. The market can always support more patient buyers who are really ready for all the bumps and bruises a home can create, and you’ve certainly earned the right to some security after everything you’ve been through in the last decade.