The Tightening Mortgage Market

It seems that every day we see reports that the credit market is tightening. I though it was time that we review where we are and how it affects the consumer.

Before we go into details I want to make a comment on current interest rates. The rate of interest one needs to pay to borrow money is directly related to the perceived risk the lender is taking when it decides to give you the loan. This applies to consumer borrowing as well as business borrowing. It also applies to the rate of return an investor wants when he purchases that closed loan from the lender.

The Federal Reserve has been lowering the rate it charges to banks to borrow money from them. With banks having a lower cost of funds this encourages lenders to offer loans to consumers and businesses at a lower rate of interest. It would seem that this would result in lower mortgage rates. Unfortunately, this isn’t happening. The perceived risk is, writing a mortgage by a lender, is greater than it has ever been. This translates into higher, not lower, mortgage rates. Until the financial market settles down, we are going to see interest rates higher than they should really be. Depending on the day, the benchmark 30-year conforming fixed mortgage interest rate with 0 points in ranging from 5.50% to 6.50%. Although still a low range by historic standards, the range would be lower if it wasn’t for the risk premium that the marketplace is factoring in on mortgages.

So don’t conclude that all the decreases in interest rates that we’re reading about in the paper have brought mortgage rates down. They haven't yet, although it may bring them down in the future or we may never see rates this low again. There is no way to accurately predict the direction.

There have been two areas of lending that have benefited from the Fed’s actions. The Prime rate moves in tandem with the Fed rate. Any existing credit line mortgages, which are typically indexed to the Prime rate, now have lower interest rates, yielding lower monthly payments. Credit card interest rates are also tied to the Prime rate so the interest due on everyone’s credit card balances has also dropped.

Now lets look at the current availability of mortgage products.

This financial crisis started in the subprime mortgage market. This is an area of lending that addresses the needs of applicants with issues that prevent them from borrowing money through the more traditional channels. The availability of subprime mortgages has almost completely disappeared. A consumer that has a less than perfect credit history will not be able to use a subprime mortgage as a tool to consolidate debt and improve their credit profile. A consumer in this situation is now limited to one course of action. That is to make timely minimum payments on all the outstanding debts and wait for this new payment pattern to improve his credit profile over time.

Homebuyers were, until recently, able to purchase their home with no money down. This is no longer available. There is still some 95% financing available, depending on the specific neighborhood, but for the most part a 10% down payment will be needed. If a neighborhood is showing signs of declining market values, 95% financing will not be offered. We are even seeing some programs holding to an 85% loan to value.

The only high loan-to-value program that is still available is the FHA program. 97% financing is still available here. The FHA loan limit was always low. It was a program designed to help first time homebuyers purchase their homes. This has limited the usefulness of this program in this region of the country. The good news is that the FHA limits have been temporarily raised. The bad news is that we don’t know as of yet what changes to the underwriting guidelines or what pricing changes will be imposed along with these new limits.

Any mortgage that exceeds the conforming loan limit ($417,000 for a one-family property) becomes a jumbo mortgage that carries a higher interest rate. Historically this rate increase has been in the 0.25% to 0.375% range. Currently this spread has increased to 2.0%. To ease the credit crunch, the conforming limit was temporarily raised at the same time the FHA limit was increased. But the same problem exists here as with FHA. The underwriting standards and any pricing issues are still being drafted and we are awaiting the details.

A common way to avoid paying mortgage insurance has been to us a piggyback or a combo mortgage. Instead of taking out one large mortgage, the borrower takes out a first mortgage at 80% and a second mortgage for the remainder. This eliminates the mortgage insurance premium that one large mortgage would require. This product is disappearing quickly and I suspect that we will no longer have it available from any source shortly. A borrower will now need to pay for mortgage insurance on all mortgages over an 80% loan to value.

Home Equity Lines of Credit (HELOC) or Credit line mortgages are now carrying a much higher interest rate. In the past, a rate of Prime was typical. Now we’re seeing pricing ranging from Prime to Prime plus 3.5% depending on the credit score and loan-to-value. Credit Scores are also influencing the maximum loan-to-value available to the borrower as well as impacting the rate.

Fewer and fewer borrowers are able to obtain "limited" or"no-documentation" mortgages. Nearly all mortgage products today require documentation confirming all aspects of the mortgage application package. This is making it difficult for self-employed borrowers to arrange financing. This type of mortgage was also utilized for borrowers with very complicated income profiles. Individuals in this category will now have to spend time and money to assemble an income package that can be understood by the underwriter.

Credit scores are playing a larger role in the pricing of mortgages. It used to be that a scores of 620 or better received the same pricing. It was only when the score was below 620 that pricing varied, based on how low the score was. Now we’re seeing pricing differences through the entire range of scores. Today a borrower with a 740 score will be priced better than a borrower with a 700 score. The borrower with a 660 score would be paying an even higher interest rate and the borrower with 620, higher still.

Applicants today are faced with a requirement to invest more money into the home they are looking to purchase. They are going to need to prove that they have the financial capability (through income documentation) and the desire to meet their contractual obligations with their creditors (through their credit profiles). There are no shortcuts right now.

There used to be a saying years ago that went, “banks only lend money to people who don’t need it”. After decades of developing new programs and standards to make homeownership more available, we have gone full circle. Banks are again lending money only to those who don’t need it!