Q&A: Lenient lending

Q: If people are allowed to re-modify their loans with government help, even with high back-end ratios, isn’t this some of the same lenient underwriting criteria that put them is this situation in the first place?

A: Since at least 2004 when I first began writing about the potential consequences associated with “affordability” loan products, it’s been obvious that people can only spend so much on housing costs before they’re overwhelmed, upside-down, foreclosed and bankrupt.

Traditionally the mortgage industry has qualified borrowers in part on the basis of “front” and “back” ratios. The front ratio is the cost of mortgage principal and interest plus property taxes and insurance – PITI. The back ratio includes PITI plus regular monthly costs such as credit-card debt, car payments, etc.

For conventional loans the ratios have been 28/36 percent for fixed-rate financing, 33/38 for conventional adjustables, 31/43 for FHA loans and 41/41 for VA financing.

The higher the allowable ratios the more someone can borrow with a given level of pre-tax income. Thus if you can afford $200,000 with a conventional loan you could borrow more with an ARM, FHA loan or VA mortgage.

As home values rose through much of the past decade, buyers turned to mortgages with more liberal underwriting standards to qualify for bigger loans. Many of these programs allowed borrowers to qualify on the basis of initial costs rather than the potential monthly costs that were likely once start rates ended. To lock-in borrowers, many “nontraditional” loan products also had hefty prepayment penalties so that it would be difficult to refinance before higher monthly costs kicked in. At the same time, down-payment requirements declined to, well, nothing, in many cases.

Under the Obama loan-modification program, borrowers facing foreclosure can have back ratios as high as 55 percent of their gross monthly income before they’re even required to have counseling. While the willingness to help troubled homeowners should be applauded, the dull reality is that such steep back-end ratios are simply unsustainable for many borrowers, if not most.

So why bother with the government’s loan program?

First, some borrowers – against great odds – will be successful.

Second, even if re-default rates are high millions of homes might be kept off the market for months under the government’s $75 billion plan, thus reducing the inventory of distressed properties. With fewer homes on the market there can be a better balance between buyers and sellers in many local markets. Translation: Local home prices may stabilize or even rise if the government effort is successful.

Third, the government programs before the Obama plan were a complete bust. The loudly publicized FHASecure program helped a few thousand borrowers at a time when a few million were receiving foreclosure notices. The Hope for Homeowners program has had just one loan approval nationwide as of this writing.

So, yes, lenient modification criteria will mean high levels of re-defaults. Unfortunately there does not seem to be an alternative solution that produces a better outcome.

Q: Do the washer and dryer automatically come with a home?

A: In some parts of the country it’s customary for the washer and dryer to convey when a home is sold, in other areas you only get hook-ups, meaning usually the pipes, drains and vents needed for a home laundry. For details, speak with your broker.

Correction

We had an example recently showing what would happen if a $150,000 loan at 6 percent interest was prepaid with an additional $100 per month. The column correctly stated that the loan term would be reduced from 30 years to 23.17 years, however the total savings should have been shown as $45,781.04. This is the difference between $173,758.80 in interest over the life of the loan at 6 percent and $127,977.76 – the total potential interest cost with additional monthly payments of $100. The mistake was mine.