What Exactly Is Behind FHA Default Rates?
In the last few years, the number of FHA loans in default has actually lowered, but they still default at a much higher rate than other loans. There’s been a lot of talk trying to explain why, but in order to get closer to the root of the issue, it’s important to cut through the noise.
No doubt you’ve heard of an FHA loan, and may even have one yourself, but let’s explore exactly what they are and what their history is.
First, a little background: The Federal Housing Administration was established in 1934 to help lower income borrowers, who otherwise would have had a hard time qualifying, obtain a mortgage. The FHA’s inception came at a time when it was common for buyers to pay 50% of a property’s value as a down payment on a short-term mortgage. This is part of why property ownership was limited to a very moneyed class, a hallmark of the Gilded Age.
So Congress created the FHA to broaden home ownership by backing mortgages with a government guarantee. This made it possible to for lenders to offer prospective borrowers more competitive interest rates on traditionally more risky loans. The boom in home ownership following World War II is as attributable to the FHA as it was to American manufacturing, economic supremacy, and the minimal structural damage sustained during the war.
An FHA home loan works like any other mortgage – aside from its government guarantee – with the main distinction being that FHA loans charge both upfront and monthly mortgage insurance premiums, often over the entire lifespan of the loan.
Probably the most glaring difference in FHA-backed mortgages is their looser requirements. All borrowers need is a minimum credit score of 580 and a 3.5% down payment. Despite this, FHA loans come with some of the lowest interest rates on the market. Remember, this isn’t because the FHA actually makes the loans, nor do they set the interest rates; they just insure them. This provides a powerful – and some would say disruptive – incentive for lenders to loan to borrowers who otherwise might not qualify for traditional mortgages.
The savings aren’t absolute, though. A slightly lower interest rate may be canceled out by mortgage insurance, which is required for all FHA loans. There are also potential lender overlays, which are underwriting requirements by individual lenders. The primary purpose of FHA loans isn’t necessarily to save money (because you can probably get a better overall deal with a traditional mortgage when you have good credit), but rather to give lower income or less creditworthy borrowers the ability to grow their wealth by purchasing real estate. To an extent, they do this job fairly well. The darker side of things, though, is that FHA loans default at a much higher rate than other mortgage products.
If you read business or economic news regularly, you can probably hear the common refrain building: “Well of course FHA mortgages default at a higher rate! The borrowers are less creditworthy, make less money, and start from behind with their loans when they pay only 3.5% down! What else does anyone expect?”
There’s a bit of truth to that, obviously. As usual, though, the full story is a little more complex. Income, rather than creditworthiness (or the implicit assumption that lower income borrowers are less responsible) is a more substantial factor here. Lower income borrowers are more susceptible to shifts in the labor market and financial emergencies such as illnesses, and are disproportionately represented in jobs with high turnover rates. They may also be in areas with relatively little economic opportunity. As an example, if the best job in a rural town is a chicken processing plant and it closes, laid off workers don’t have as many options as their city-dwelling counterparts. In other words, they’re less secure and less able to handle an instance of financial stress than a higher income family.
Contrary to popular belief, it’s not just low-income borrowers who take advantage of FHA loans; many times, higher income borrowers use them to buy a home they otherwise might not be able to afford. Much like their lower income counterparts, a financially strained upper middle-class borrower may not be able to weather the storm of a job loss or illness (which is why we always say no matter what your income is, don’t buy more house than you can reasonably afford). This is often left out of the equation when considering the default problem with FHA loans, and the reality is that borrowers of all levels of income are contributing to it.
A common comparison here is VA loans. These are backed by the government as well with similar terms and conditions, but have a much lower default rate. It’s important to remember a few differences here that explain this, which can help us understand why FHA loans default with such a high frequency.
The biggest difference between FHA and VA loans is that the government doesn’t guarantee the full amount of a VA loan, in contrast to the FHA’s 100% guarantee. This causes lenders to assume more risk and, as a result, have stricter underwriting requirements. The VA also has a statutory requirement to service its borrowers, and as a practical matter, that requires direct contact. The FHA doesn’t engage in direct contact with borrowers; the servicer contacts the borrower. The VA, on the other hand, intervenes at an earlier point in the delinquency cycle and in a more reliable, uniform way.
Occasionally the claim is put forth that military veterans are more disciplined or take financial obligations more seriously, and are therefore less likely to default. This may be true, but it’s extraordinarily difficult to measure (even for economics). What’s often overlooked, in addition to the factors we just listed above, is that veterans are a smaller pool of borrowers who, as a general rule, tend to have more stable employment prospects following service. You have to keep in mind the groups in comparison: low income borrowers in general (who have low income for a variety of reasons), and veterans in particular, who are more consistent and predictable as a demographic. Veterans are also able to take advantage of the GI bill, and may be more likely to have college degrees as a result. Because FHA loan recipients are extremely varied, even across income levels, trying to compare them to veterans is like measuring apples against oranges.
So how can we reduce the rate at which FHA loans default? Some have argued that the conditions that precipitated the FHA’s establishment no longer exist (50% down payments and balloon mortgages), and that the current norms of the market should be allowed to supplant the FHA. It’s been claimed that competitive interest rates and quality loan products can be offered without the need for government backing, which might stabilize the real estate market. While the first half of that is true, there’s not as much evidence to suggest that the conditions that tend to destabilize markets, such as runaway speculation, overpricing, and overvalued loan securities which become toxic assets, are inextricably linked to FHA loans.
Another solution might be to consider residual income rather than just debt-to-income ratios in FHA loan underwriting. FHA loans usually don’t factor in residual income to their calculus, and this has the potential to be the driving factor in their high default rates. While DTI as a ratio can be relatively consistent across different income brackets, residual income is not.
While factoring in residual income may limit the ability of some borrowers to get a mortgage, it could potentially help stabilize the default rate of FHA loans. This might present less of a shock to the housing sector than ending the program entirely, while also allowing market forces to exert greater influence. Now that you’ve heard our perspective, what do you think are the reasons behind FHA default rates, and how could they be solved?
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