Why Aren’t 3-Percent Mortgages Catching On?

When it comes to mortgages, the prevailing theory is that smaller down payments are a sure way to get more buyers into the marketplace. It turns out that …

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When it comes to mortgages, the prevailing theory is that smaller down payments are a sure way to get more buyers into the marketplace. It turns out that an even better approach is to simply lower the mortgage insurance premium (MIP), an approach that can save borrowers big money.

You can’t have a better example of this than the ongoing battle between Fannie Mae/Freddie Mac and the FHA to attract entry-level buyers. The winner, at least to this point, is the FHA, which has routed the two giant government-sponsored enterprises (GSEs) and confounded its critics with a big surge in originations.

The Battle For Borrowers

At the end of last year, both Fannie Mae and Freddie Mac said they would buy conforming loans from local lenders with as little as 3 percent down for first-time buyers. That’s a big break from the usual 5 percent conventional standard. The lower down payment requirement was also something else: a direct challenge to the FHA’s 3.5 percent down payment benchmark.

The FHA had planned to introduce its own 2015 budget-cutter, the Homeowners Armed with Knowledge (HAWK) program, a plan that would have rewarded first-time borrowers with lower rates for good payments. While this may sound like an obvious idea, it mysteriously offended someone on Capitol Hill. We know this because the budget bill passed at the end of 2014 gutted the FHA program before it ever got off the ground: "SEC. 235. None of the funds made available by this Act nor any receipts or amounts collected under any Federal Housing Administration program may be used to implement the Homeowners Armed with Knowledge (HAWK) program."

Challenged by Fannie Mae and Freddie Mac on one side, and hammered by Congress on the other, the HUD surprised everyone with a January announcement reducing annual MIPs on virtually all new FHA loans by 0.5 percent.

In the world of Washington politics, the FHA had out-foxed congressional critics and gotten around the HAWK ban by extending lower MIP rates to everyone, not just first-time buyers. Congress could tell the FHA to go back to the higher rates, but that sounds like a tax increase, a label that terrifies most on Capitol Hill.

The Market Speak

So which would consumers see as the better deal: A loan with less money down, or financing with lower annual costs?

Reducing the down payment for a $150,000 loan from 5 percent to 3 percent saves borrowers $3,000 ($7,500 less $4,500). Not only that, the new down payment requirement is $750 less than the up-front money demanded by the FHA ($4,500 versus $5,250).

The opportunity to save $3,000 when buying a home is significant, especially in a tight economy, so it would seem the GSEs had a winner on their hands.

Meanwhile, the FHA was keeping its 3.5 percent down payment requirement in place. It was also hanging on to its 1.75 percent up-front MIP. What was changing was the annual MIP: it was reduced from 1.35 percent to 0.85 percent.

How did the marketplace vote?

Fannie Mae called its 3-percent effort the MyCommunityMortage (MCM) program, and in the first six months of this year, bought 9,000 loans from local lenders. Figures for the comparable Freddie Mac program, Home Possible Advantage, will not be available until the company’s 2014 annual report is released.

The story with the FHA is different. As of June 2014, it had insured 566,612 loans—a figure that rose to 736,393 mortgages during the same period this year, an increase of almost 170,000 mortgages.

There are several reasons why the FHA program has been such a huge success.

First, while conventional first-time borrowers can cut down payment costs with the GSE product, the savings aren’t that great in the overall scheme of things.

For instance, in our example with the $150,000 mortgage, a borrower would save $750 up-front with a conforming product when compared with an FHA down payment. But with an FHA loan, the borrower would save roughly the same $750 in the first year with the lower annual mortgage insurance premium when measured against a 2014 FHA loan; there would be more savings each year the FHA loan was outstanding. In other words, the lower down payment is a one-time deal, while a reduced insurance rate produces an ongoing stream of savings. Since the typical loan is now held for six years, a borrower can get much bigger savings with the FHA program.

Second, when Fannie Mae introduced MyCommunityMortgage, it required lenders to manually underwrite the loan. However, MyCommunityMortgage has now been replaced with the HomeReady plan. The big difference? The new program can be automatically underwritten, a big savings of time and effort, and something that will make the program more attractive to lenders.

Third, many lenders—and first-time borrowers—view FHA-backed loans as the preferred lending product for this segment of the market, one that’s a little more forgiving of lower FICO scores and less-than-perfect documentation. Fannie Mac will eventually do better because approximately 600 lenders have now originated its 3-percent loans, and with automated underwriting, it becomes a more attractive product to sell.

"While the mortgage industry picks winners and losers in the battle for low down payment loans, the real winners are borrowers—especially first-time homebuyers," noted Rick Sharga, executive vice president at Auction.com, an online real estate marketplace. "In today’s exceptionally tight credit market, any program that allows qualified borrowers to more easily get a more affordable home loan is good for the housing market, good for the economy and certainly good for the borrower."

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