March Madness - Subprimes Benched in Favor of FHA Loans

Posted on March 22nd, 2007

One of the great facets of the American dream is the notion that everyone should be able to own their own home, despite their race, background, or financial situation. And while purchasing a home isn’t easy for most Americans, it is an especially difficult process for some. Lately, the solution to buying a house with little cash or a poor credit rating was to use a sub-prime mortgage.

Sub-prime mortgage loans are utilized by people with poor credit history who can therefore not obtain prime market interest rates. In order to compensate for this higher lending risk, the lending institution (usually a bank) charges a higher interest rate, usually directly proportional to the credit profile of the borrower. The problem is that many institutions offering sub-prime mortgages have stopped offering these loans or gone bankrupt recently. This is due to a number of sub-prime borrowers being unable to make their payments and thus going default on the loan, sometimes after a period of 2 or 3 years. Therefore, with the use of sub-prime mortgages falling fast, something needs to fill that gap so that individuals with poor credit who are looking to purchase a house can still afford to do so.

What many believe will fill this gap is the FHA - or Federal Housing Administration - loan market. Created in the 1930s to help eliminate the home loan problems associated with the Depression, the FHA has since helped finance over 30 million homes in the U.S. Despite this longstanding tradition and stabilization in the FHA, their mortgage loans have recently become unpopular as sub-prime loans could offer higher loan limits with exotic features like “interest-only” and “no money down.” The fact is that FHA loans do require money down (usually 3% of the total loan amount) and do have loan limits (currently approximately $363,000). The immediate benefits of an FHA loan, however, are that it is not subject to fluctuations in the stock market, as sub-prime loans are.

To understand this difference, remember that FHA loans are backed by the government, which has both positive and negative aspects. On the positive side, FHA loans are fixed-rate and are not subject to wild market variation, and as they are backed by government bonds, the lenders feel safe offering FHA loans to individuals with little cash or poor credit.

Negatively, as FHA loans go through government offices, this inevitably means that there is a certain amount of extra paperwork and bureaucracy, which means a slow and cumbersome process when compared with sub-prime loans. Furthermore, as stated above, FHA loans do have a loan limit and a down payment requirement. However, it is worth noting that several legislators are making moves to change these and other aspects of FHA loans to meet the demand created by the decreasing sub-prime market. As FHA has been accused in the past of being slow to adapt to the current mortgage situation, many believe that these changes will go through so that once again Americans who need help in purchasing a home will turn to government loans and not private loans from new, possibly inexperienced, lenders.

Despite helping customers with a low credit rating (usually below 620) or with small cash reserves, the FHA is also useful to minorities. It has been documented time and time again that African Americans, Hispanics, and other minorities often pay an average 3% higher interest rate than current market rates. Even though the government has taken steps in the right direction to solve this problem (such as passing the Home Mortgage Disclosure Act), many minorities still find it difficult to obtain a mortgage that they can afford. With an FHA, a much wider portion of the population is qualified, and with safe borrowing procedures,as guaranteed through the government, minorities will be able to obtain a loan at the same rates as anyone else.

With improvements in the current structure of FHA loans, such as modernization of processes, flexibility and customer service, it is believed that a huge percentage of the housing market may again turn to FHA mortgage loans. It is difficult to tell where the sub-prime market will go from here, but if borrowers continue to default on these popular loans, it is likely this market will decrease, paving the way for a surge in popularity of the FHA loan in the years to come.

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