New Rules Signal Easing of Credit Requirements for Mortgages


A recent Harris Poll revealed that 80% of Americans still think owning a home is part of the American dream. After the financial crisis of 2007-2008, mortgage bankers tightened lending criteria, making it much more difficult for people to qualify for new mortgages. Lending criteria has remained tough since those times; some experts think the ongoing depression in real estate prices has been exacerbated by tight lending guidelines. Now news comes that lenders will be removing some of the barriers to getting a new mortgage because of changes in the housing secondary market.

One of the obvious reasons banks tightened their lending requirements was because of the glut of loans that went bad after the financial meltdown. Loose lending guidelines were the norm pre-2007 and it was determined that some of the delinquencies in the market happened because some of the loans should not have been made in the first place. In the wake of defaults, banks who sold these poorly underwritten loans on the secondary market were heavily penalized by secondary market institutions.

Why Banks Sell Loans on the Secondary Market

Banks want to make mortgage loans because they make money doing so:

  1. Mortgage fees. Each time a loan is made, the consumer pays fees to the bank, often a percentage of loan amounts. This is one of main ways banks make their money on loans.
  2. Interest on loans. The interest from each payment goes to the loan holder, however interest from loans are one of the smallest sources of profits in mortgages, as interest rates continue to be very low.
  3. Loan Servicing. Banks sometimes buy or retain servicing rights on a loan, picking up fees for collecting payments, issuing statements, implementing policies and procedures, maintaining customer support staff, and distributing funds to the loan holders.
  4. Selling Loans on Secondary market. A bank can sell the servicing of the loan and continue to collect interest, or it can sell the servicing along with the loan.

In order to keep making loans and thereby collecting fees, banks need funds. Without the secondary market to sell loans to, the bank would quickly go through their funds and be left with no money by which to make loans.

The secondary market consists of Fannie Mae and Freddie Mac, other nationwide lenders such as Wells Fargo, Chase, and financial institutions such as pension funds and insurance companies.

Keeping the Secondary Market Happy

Fannie Mae and Freddie Mac are two of the biggest government loan guarantors and comprise 54% of the secondary market. The penalties imposed by Fannie Mae and Freddie Mac on the banks for making shoddy loans pre-2007 consisted of making banks repurchase tens of billions of dollars in loans that didn’t meet their credit standards after loans in their mortgage pools went delinquent, thus depriving them of funds by which to make new loans.

Burned by Fannie and Freddie repurchases, lenders decided to minimize future risk by putting into place credit overlays, or additional credit requirements necessary for securing a new mortgage.  By adding additional requirements over and above the published secondary market guidelines, banks wanted to ensure Fannie and Freddie would not force a repurchase of any loans made if they happened to go delinquent. The increased overlays made it very difficult for borrowers with less than perfect application files to get a loan.

Some examples of credit overlays:

  • Increased credit score requirements (insisting on higher credit scores than FNMA and FDLMC guidelines).
  • Increased documentation requirements, such as bank statements.
  • Increased minimum down payments.
  • Lowered debt-to-income ratios. Lowered debt to income ratios means that lower amounts of debt are allowed by borrowers.

New Rules

New rules implemented December 1, 2014 will relax the credit standards imposed by Fannie and Freddie. The relaxation mainly comes in the form of more clarification on when lenders would be penalized for making mistakes in lending to more risky borrowers. As a result, banks will know exactly what the credit requirements are and will not have to impose such strict credit standards on new borrowers.

In an October 2014 address to the Mortgage Bankers Association, Melvin Watt, director of Federal Housing Finance Agency said, “Going forward, Fannie and Freddie would not force repurchases of mortgages found to have minor flaws if the borrowers have near-perfect payment histories for 36 months.” He also said flaws in reporting borrowers’ finances, debt loads and down payments would not trigger buy-back demands so long as the borrowers would have qualified for loans had the information been reported accurately.

The Urban Institute, a Washington think tank, has said relaxed standards could mean as many as 1.2 million more loans per year could be written, which should have a positive effect on housing prices, unemployment and the economy.

Not all lenders are ready to embrace the new standards. Wells Fargo, the largest mortgage lender in the U.S., will adopt the new standards, while U.S. Bancorp will keep its mortgage overlays in place.

What “Relaxed Standards” Means

Before the December 1, 2014 relaxation of credit standards, banks had been insisting on a minimum credit score of 640. Under the new standards, more banks will be able to qualify buyers with a 620 credit score. While a 620 score has been the Fannie Mae credit threshold for quite a while, most lenders were not willing to go that low (a credit score overlay of 640 was put into place).

It is unclear about the extent of the reduction in documentation required to qualify, however, lenders will be able to lend to borrowers with debt ratios up to 43% of gross income, up from 36%.

Before Fannie Mae relaxed the down payment requirement for first time homebuyers on December 8, 2014 to 3%, only FHA borrowers could qualify with down payments of 3%; conventional loan (those sold to Fannie Mae and Freddie Mac) borrowers had to put 20% down. Lower down payments on conventional loans could mean lower costs to consumers, as conventional loans are typically cheaper than FHA loans. FHA loans require fairly daunting monthly mortgage insurance premiums (MIPs) on loans with a higher loan to value percentage than 80%. In addition to the high MIP (the rates for FHA MIPs have been raised 5 times in recent years), it’s nearly impossible, short of refinancing, to get this MIP removed, even after the threshold 80% loan to value has been reached. On conventional loans, once the loan to value ratio reaches 80%, the borrower no longer has to pay MIP.

Posted in Mortgages
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