FHA May Clamp Down on Debt-to Income Ratios

The Federal Housing Administration is considering tightening borrowers' debt-to-income ratios, a move that would prevent the most highly leveraged consumers from qualifying to buy a home.

The agency has yet to determine what the new minimum and maximum ratios would be and when such changes would go into effect, but the very fact that FHA is contemplating such a move is worrisome to some lenders who say a tightening would exclude more borrowers from the still-fragile housing market and potentially cause home prices to fall further.

From FHA's perspective, putting a hard cap on debt-to-income ratios would potentially lower its delinquency rate and keep its Mutual Mortgage Insurance fund on sound financial footing.

"It doesn't do anybody any good if the borrower can't meet their debt obligations," Robert Ryan, FHA's acting commissioner, said in an interview Thursday. "We absolutely have to make sure borrowers are in a position to sustain homeownership."

For two years now the agency has struggled to tighten guidelines and raise the bar for lenders. But FHA has tried to guard against being adversely selective by tightening its debt ratios.

FHA loans are more or less the only product lenders can offer borrowers who have little money for a down payment (outside of the government's loan programs for veterans or rural residents).

Though some of the largest banks already have their own DTI caps, some lenders have been willing to give up credit standards to increase loan volume.

FHA is looking at the variables that go into its automated underwriting system Total Scorecard, which considers a variety of factors when automatically approving a loan.

"We're not sure the model is predicting the outcome," Ryan said. "We might tighten the DTI ratios up and that would mean instead of an automated approval the lender would do a manual review of those loans to make sure they were comfortable the borrower had more income or savings and there were some extenuating circumstances that would warrant the approval of that loan even if there was a slightly higher DTI."

One possible scenario would be for FHA to adopt the debt ratios of its short-refinance program, which was designed to help underwater borrowers refinance into an FHA loan. To qualify, a borrower's monthly mortgage payment, including a second mortgage, cannot be greater than 31% of his or her pre-tax income and the total DTI ratio cannot exceed 50%.

Lenders say FHA routinely approves borrowers with back-end ratios above 50%.

Currently a borrower with a high FICO score could qualify for an FHA loan even if their total pre-tax income allocated for housing was 46.9% and their total debt load was 56.9%, according to several lenders. The borrower would have to have a high down payment and significant cash reserves.

Conversely, for borrowers with high loan-to-value ratios, Fannie Mae and Freddie Mac require a maximum 28% front-end DTI ratio and 36% back-end on loans they purchase. For manually-underwritten loans, Fannie and Freddie allow a maximum of 45%, though that may go up to 50% with strong compensating factors.

"A debt-to-income ratio over 50% leaves little room for error in a borrower's monthly budget," said David Zugheri, president of the Houston lender Envoy Mortgage. "Once you take income taxes out, a borrower could be left with only 25% of their gross income to live on, which includes utility bills, cell phone, insurance and food."

Rob Chomentowski, a senior loan officer at Affinity Financial in San Diego, said high debt loads are a better predictor of risk than high down payments.

"People should not have 55% of their income before taxes going to debt," Chomentowski. "There's a lot of talk about raising the down payment and there should be more talk about tightening the DTI ratios, which makes the loans more secure."

But such a change could adversely impact housing prices.

"If FHA does lower the back-end ratio, it would take a lot of borrowers out of the market, which isn't a bad thing, but that will take home prices down more," Chomentowski said.

Some lenders said they would be unlikely to manually underwrite a loan that was not approved by FHA's automated system.

John Walsh, president of Total Mortgage Services LLC in Milford, Conn., said tightening debt ratios while pushing for manually-underwritten loans was a "double-edged sword."

"The ratios are what they are and nobody is going outside those," Walsh said. "Everybody is gun shy these days. Would I like to put more borrowers in homes? Without a doubt. But I'm not going to jeopardize my relationship with FHA by going outside that box. Send me the guidelines and if it's an exception by FHA to do a manual underwrite, I don't want to do that."

Manual underwriting is expected to become a much bigger issue going forward because so many more borrowers applying for loans today went through a bankruptcy or a foreclosure during the recession.

Borrowers can apply for an FHA loan two years after a bankruptcy or three years after a foreclosure, but the loans all must be manually underwritten and have a maximum back-end DTI of 41%.

Debt ratios also are playing a role in the larger debate over proposed risk retention requirements and what constitutes a "safe and sound" mortgage.

The Mortgage Bankers Association's Chief Executive David Stevens said in an interview Tuesday that FHA is trying to put "reasonable" DTI caps on the overall program.

"A borrower with a 10% downpayment and reserves would probably qualify for higher DTI, but FHA may want to keep the DTIs lower for young first-time homebuyers moving from a rental to ownership," said Stevens, the former commissioner of FHA, who left the agency in mid-April.

(Stevens has been pushing for a narrow definition of a "qualified residential mortgage," without hard limits for down payments, DTI or loan-to-value ratios.)

Maurice Jourdain-Earl, a managing director at ComplianceTech, a lending industry consulting firm, said he is concerned that tightening the range of acceptable DTIs would impact minority borrowers.

"FHA lowering debt-to-income ratios will have the same effect as QRM. The people who can afford it the least will be adversely impacted," Jourdain-Earl said.

FHA's market share has surged to nearly 30% during the downturn from 3% in 2006, largely because it has the loosest guidelines among loans guaranteed by the federal government. Higher volume and share has been accompanied by higher defaults and losses, though there's been a recent decline in loans that were 90 days overdue or in foreclosure. According to the MBA, 8.04% of FHA loans were seriously delinquent at the end of the first quarter, down from 8.46% in the fourth quarter and 9.1% a year earlier.