The story of the collapse of the housing market is familiar to every American. How too many people took out subprime mortgages that they could not afford, and when home prices fell and adjustable interest rates rose millions of homeowners were forced into foreclosure. Today, many prospective homebuyers, especially those with poor credit, have heard about loan programs offered by the U.S. Federal Housing Authority (FHA).
Borrowers, especially those with poor credit, may wonder if FHA loan programs are a replacement for subprime lending. The risks and history of the subprime market make many borrowers jittery, but many consumers don't know the facts about FHA programs and what it takes to meet FHA qualification guidelines.
To compare FHA loan programs with subprime mortgages, you first need to understand the subprime market.
Subprime lending means making loans that are in the riskiest category of mortgage loans. Risk is determined by many factors including the borrower's credit rating (typically a FICO score below 640), the size of the loan, the structure of the loan, the ratio of the borrower's debt to income, the ratio of loan to value, and the documentation on loans that do not meet Fannie Mae or Freddie Mac underwriting guidelines for prime mortgages (these are called "non-conforming loans").
In recent years, culminating in the 2006 and 2007, subprime lending grew into a huge segment of the mortgage industry. By March 2007 the total value of subprime mortgages in the U.S. was estimated at $1.3 trillion. But borrowers defaulted in record numbers, and by the third quarter of 2007 subprime adjustable-rate mortgages (ARMs), which comprised only 6.8% of U.S. mortgages, accounted for 43% of the foreclosures. Approximately 16% of subprime ARMs were either 90-days delinquent or in foreclosure. By May 2008 the delinquency rate was 25%.
The basic fact is that a subprime mortgage, just like a conventional mortgage, uses a house as collateral for the loan. If the loan defaults, foreclosure proceedings commence and the borrower ultimately is faced with losing their home. A U.S. government safety net is not part of the equation in this scenario.
FHA Loans Provide Insurance
The FHA can provide a safety net. But in contrast to banks and other lenders, the FHA does not make loans. It does not build, buy, or sell houses. To get a mortgage or a home equity loan, you have to go to a lender such as a bank, just as you have always done.
What is commonly called an "FHA loan" is really an insurance policy. If a borrower meets the FHA credit requirements, The FHA provides insurance to the lender and makes it possible for the lender to assume less risk. If the homeowner defaults, FHA will pay a claim to the lender.
How FHA Loan Programs Can Help You
If you are a poor credit risk, you may not qualify for the best (or prime) lending rates. Since the global financial crisis, lenders have tightened their requirements and many borrowers who qualified for subprime or even prime loan packages are being denied credit. What an FHA loan program can do for you is get you better terms from your lender and perhaps make the difference between getting a loan and being denied.
Here's the process: when you go to an FHA-approved lender such as a bank or mortgage company, the lender may ask that you apply for FHA mortgage insurance. You may also request that you be considered for FHA mortgage insurance. A loan that is offered to you must meet certain requirements established by FHA to qualify for insurance. The FHA then investigates your finances and credit history. If you meet FHA credit requirements, the FHA insures the lending institution against loss of principal in case you fail to pay your mortgage. In some cases the lender may be able to give you a lower interest rate than you otherwise would have received.
If you have good credit you may not want an FHA loan because the FHA charges a small fee to you, the borrower, and therefore you may be able to get private mortgage insurance at a lower rate. But if you have poor credit, it is definitely worthwhile to consider an FHA loan.