Home Equity Loans Lose Business to FHA

Federally guaranteed FHA mortgages are gaining momentum as lenders look to return to more traditional and conservative underwriting practices.

Bob Dylan used to sing, "The times they are a-changin'." Certainly this is the case in the mortgage industry, where a big-time crisis has left borrowers and lenders reeling. As part of the recovery process, lenders are rethinking underwriting practices and expressing a renewed interest in a more traditional approach to lending.

When old seemed old-fashioned

At the height of the housing boom, lenders guided their lower income borrowers into creative subprime mortgages, like an adjustable-rate loan (ARM) with low initial payments. If savings were tight, a home equity loan was recommended to provide extra cash. The attractiveness and ease of subprime mortgages and home equity loans caused some of the more conservative mortgage products to fall out of favor in the marketplace. FHA loans and private mortgage insurance (PMI) were hit particularly hard.

What's old is new again

As it turns out, that strategy was far too aggressive. Many borrowers took on loans that they couldn't afford, and struggled when their adjustable interest rates began to rise. Then they watched their home equity evaporate as home values declined. Lenders and investors, faced with mounting losses, have since decided that the uninsured subprime mortgage wasn't such a great thing after all. Now they're calling for a return to the old way of doing things.

That old way has more to do with FHA loans and PMI than with home equity loans and option ARMs. The FHA has offered affordable mortgages to less-qualified borrowers since the 1930s. The program has features that appeal to both borrowers and lenders alike. That includes:

• For qualified borrowers, the low down payment requirement of 3 percent is more realistic than a 20 percent requirement. The lesser upfront cash outlay also reduces the borrower's need to layer debt with a home equity loan on top of a first mortgage.
• For lenders, the federal guarantee eliminates risk. At a time when defaults are on the rise, more and more lenders are realizing just how valuable that federal guarantee really is.

PMI is an industry veteran, as well. It was once a standard requirement for homeowners who had less than a 20 percent down payment. In recent years, however, lenders were guiding mortgage applicants to avoid PMI with home equity and piggyback loans. With uninsured defaults on the rise, those avoidance strategies are fast-disappearing.

Going forward, lenders expect to increase FHA production and decrease home equity loans. Funds available for mortgage lending are in short supply, so lenders need to be sure that they use them wisely. Right now, federally insured mortgages are a much safer choice than home equity loans.

Today's mortgage environment has lenders strumming the "better safe than sorry" ballad. While this might mean a more complicated qualification process for some borrowers, it's to everyone's benefit that lenders enforce a more conservative approach going forward.