Here at MassHousing our loans to homebuyers sometimes can raise an eyebrow or two.
First there’s the fact that we makes loans to homebuyers and homeowners with modest incomes. Then there are our low downpayments (as low as 3%). Most recently we drew some attention for offering a loan that allows a 3% downpayment but does not require the borrower to pay mortgage insurance.
To some people this sounds risky; they are tempted to brand us as a “subprime lender.” Post-2008, there’s really no stronger accusation in the home mortgage industry. Add to that the fact that we are a public entity—albeit one that does not use taxpayer dollars—and skeptics wonder if we’re not being irresponsible and embracing a discredited form of lending that started all the trouble.
This is an understandable concern and one that deserves a thoughtful response. That’s what today’s blog post is about.
Defining Subprime
Given how frequently the term “subprime” is used, it is surprising that there is no formal definition for the word. A Wall Street Journal blog post from March of 2011 commented on this and we recommend you look it over. That post also refers to the FDIC, which way back in 2001 published what it believed were some tell-tale signs of subprime loans.
While there is no textbook definition for a subprime loan, our review does show that there is some consensus around a few major characteristics. Let’s look at them one-by-one and compare them with some key MassHousing guidelines.
MassHousing vs. Subprime
One thing that appears clear is that any borrower who obtains a subprime loan probably has “damaged” credit. The FDIC suggests that credit scores below 660 warrant a subprime loan; other sources consider credit scores of 620 or lower to be subprime territory. MassHousing’s average credit score is about 740 with a minimum score for most of our programs at 680, which cannot be considered damaged credit by any stretch.
Another generally agreed-upon characteristic of a subprime loan is a higher-than-normal interest rate. This is to compensate for the higher risk taken by the lender in making a loan to someone with a lower credit score and a history of missing payments. MassHousing‘s interest rates are typically at or below market.
A third nearly universal attribute of a subprime loan is a borrower’s high debt-to-income ratio, typically 50% or more (i.e., the borrower spends 50% or more of their income on outstanding loans and credit card debt, for example). Here again, a MassHousing loan is far more conservative: our maximum total debt-to-income ratio on a 3% downpayment loan is 41%.
Another hallmark of subprime loans is the documentation—or sometimes lack thereof— required to qualify. Many subprime lenders offer no-income and/or no-asset verification loans, or loans with stated and unverified income. MassHousing verifies and documents all income, employment and assets.
Subprime mortgages often have variable terms, with adjustable interest rates, payments that increase over time and the potential for negative amortization. In contrast MassHousing loans are “plain vanilla,” 30-year, fixed-rate mortgages with no increases in the principal and interest payments over the life of the loan.
The absence of mortgage insurance most assuredly does not constitute a characteristic of subprime loans. It’s worth noting that one of the leading affordable housing programs in Massachusetts, the Soft Second Mortgage, has touted increased affordability created by the elimination of mortgage insurance. They even have a “piggy-back” mortgage which some also mistakenly classify as a subprime characteristic. The Soft Second has long been touted as a safe and affordable product for low- and moderate-income homebuyers.
Income and Downpayments
It is worth noting a couple of other things that do not turn up in a review of various definitions of subprime loans: low downpayments and low-income borrowers. This will come as a surprise to some casual observers, who assume that a low-downpayment loan to a person of modest means is a recipe for failure.
That is not to say that downpayments and a borrower’s income aren’t relevant. However, our experience has shown that a low downpayment is not a sure sign that the borrower will get into trouble. Nor is the presence of a 20% downpayment or equity a guarantee that a loan is not subprime. You might be surprised to learn that low-downpayment lending (i.e., loans where the borrower puts down less than 20%) goes back to 1957 when a private mortgage insurance company called MGIC introduced mortgage insurance and opened the door to homeownership for millions of Americans.
When it comes to income, what matters most is not how much the borrower earns but whether or not the loan they take out can be repaid with that income. Lower-income people are no less reliable than those with bigger paychecks when it comes to making mortgage payments, as long as their housing payment is a reasonable percentage of their income.
More important than the size of the downpayment or a borrower’s income is their credit history and debt-to-income ratio. At MassHousing we underwrite loans to make sure that the homeowner can afford the payments for the long term. Many MassHousing borrowers have strong credit histories and a stellar record of making their payments on time, even though they could afford to make a downpayment of just 3% (keep in mind a 3% downpayment on a $250,000 home is still $7,500). You may be surprised, as we were, that many subprime loans originated after 2000 ignored all other risk factors as long as a borrower had 20% downpayment or equity.
Delinquencies and Foreclosures
Finally, for anyone who still might be skeptical, let’s look at delinquency (late payments) and foreclosures. Surely just about everyone would agree that when the housing bubble burst, most loans that might qualify as “subprime” became seriously delinquent and many went into foreclosure. In fact that is true, and today according to the Mortgage Bankers of America, the delinquency rate for subprime loans in Massachusetts is over 20%. Even Massachusetts loans insured by the Federal Housing Administration (FHA) have a delinquency rate over 11%. In contrast, as of April 30, 2012 just 3.5% of the low-downpayment loans insured by MassHousing’s Mortgage Insurance Fund were delinquent while our foreclosure rate was just 2.0%.
Bad Loans and the Bubble Burst
Consumers are right to be outraged at the irresponsible lending (and in some cases irresponsible borrowing) that went on before the bubble burst. The biggest culprits, however, were not low downpayments or all loans sold to Fannie Mae or Freddie Mac, for instance. Instead they were loans that defied common sense, such as mortgages that did not require income or employment verification; negative amortization and adjustable-rate loans with extremely low teaser rates and dramatic rate increases after the teaser rate expired. MassHousing did not make these types of loans and never will.
Since 2008, it has become tempting to oversimplify the mortgage problem, to categorize anything other than a 30-year, fixed-rate loan with a 20% downpayment as subprime. Unfortunately it’s not that easy, and frankly, if those were the only loans available the housing market would be even more depressed than it is today. A 20% downpayment on a $250,000 home – which is about the median price of a home in Massachusetts today – would be $50,000. Even a 10% downpayment would be $25,000.
Good Loans and Good Lending
There are no shortcuts when it comes to responsible mortgage lending. There is no single cookie-cutter approach that guarantees success. Each borrower is different and the responsibility falls squarely on the lender to analyze each borrower’s credit, income, employment and debt burden to determine what they can afford over the life of the loan.
MassHousing’s track record proves that low-downpayment lending to people with modest incomes can be successful. By any measure these are not subprime loans. In fact these days, with their strong record of repayment and low foreclosure rates, MassHousing’s loans are just the kind that most conventional lenders would be pleased to have on their books.
The types of loans that we make may not be considered mainstream, but then again ours is not a mainstream mission. MassHousing’s mandate is to find innovative ways to help people with modest incomes buy a home, especially in times when they are not adequately served by the conventional market. The year 2012 definitely qualifies as one of those times.