FHA: A bigger down payment isn’t necessarily better

The FHA’s new commissioner, Bob Ryan, has been on Capitol Hill recently giving his view regarding the qualified residential mortgage (QRM),  the home loan that is destined to play a big role in the mortgage market looking forward.

Under the Dodd-Frank Wall Street Reform Act, lenders can make QRMs or loans which are not QRMs. This is not a light choice, however. The law passed last summer virtually requires lenders to make QRMs. Why? If as a lender you originate a loan which is not a QRM, you must keep a reserve equal to 5 percent of the loan amount.

What is a QRM?

The big issue, then, is what is or is not a QRM. Speaking on Capitol Hill, Ryan explained that:

With the financial crisis, we saw how bundling and packaging mortgages to sell on Wall Street with no accountability helped lead to the erosion of lending and underwriting standards that fed the housing boom and deepened the housing bust. Dodd-Frank specifically requires that securitizers or originators have ’skin in the game’ by retaining at least 5 percent of the credit risk and the proposed rule sets out a variety of options to accomplish that mandate.

QRM: Shouldn’t be all about the down payment

So far, we know that FHA mortgages, VA loans and conventional loans sold to Fannie Mae and Freddie Mac are already QRMs. But what about other loans, what standards are appropriate?

“While there is no question that larger down payments correlate with better loan performance, down payments only tell part of the story,” said Ryan.

I agree.

Down payment vs. credit score

Working from FHA loan guidelines and experience, Ryan explained that the need for a high down payment can be off-set with a solid credit rating:

FHA uses both downpayment and FICO scores to allocate credit assistance, which, together, we have found to be a much better predictor of loan performance than just one of those components alone. For instance, FHA insured loans with LTV above 95% and a FICO score above 580 perform better than loans with LTV below 95% and a FICO score below 580, while loans with a LTV above 95% and a FICO score below 580 perform significantly worse than all other groups, as illustrated below.

Translation: The FHA has found that a high credit score is a better predictor of loan success than a larger down payment.

There is now some discussion regarding whether to require loans with at least 10 percent down to automatically qualify for the QRM standing, or whether the down payment standard should be higher or lower.

Can’t forget about good credit

Ryan does not particularly come out in favor of any given choice, but what he does say is that the focus on down payments may miss the need to assure a good credit history:

Given the exigencies of strong underwriting for healthy, sustainable mortgages, we must be mindful of the trade-off presented by the current definition of QRM between improvement in loan quality and affordability and accessibility for prospective homebuyers. In other words, how much lift to performance do we get to the exclusion of creditworthy borrowers…?

Stay tuned, for this down payment standard is expected to be a continued topic of discussion amongst federal regulators as the QRM definition is open for public comment.

Peter G. Miller is syndicated to more than 100 newspapers and operates the real estate news site, OurBroker.com.