FHA Versus Subprime: Why They’re Different

by Peter G. Miller
June 29th, 2009

I keep reading allegedly-helpful articles and blogs which compare FHA loans to subprime lending, as if the two were the same.

FHA and subprime loans are not the same, not even close.

Part of the thinking, such as it is, behind the comparisons is political and philosophical — some folks are opposed to the FHA for the very simple reason that it’s a government mortgage insurance program which competes with mortgage insurance companies in the private sector. This is the moment when you hear talk, oh my, regarding socialism when the more important issue is that the FHA program has helped insure some 34 million loans since 1934.

Subprime Loans

Subprime real estate lending is generally defined as mortgages for individuals with weak credit. If we think of real estate loans in terms of prime financing for those with great credit and ALT-A financing for those with lesser credit or who want to borrow more than prime programs generally allow, then subprime loans are for folks with credit so weak that they cannot get either prime or ALT-A mortgages.

To make up for their poor credit standing, subprime borrowers pay higher interest rates. The irony, of course, is that the people who can least-afford big monthly expenses are the very people most likely to pay such high costs.

One idea is to make NO loans available for subprime borrowers, thus solving the problem of undue lender risk. However, if we have no subprime borrowers we also have fewer home sales. Less demand equals lower home prices, something very few owners favor….

We ought to have subprime loans because over time people can improve their credit standing. That means there is the potential to refinance from subprime into something better, say an Alt-A or even a prime loan.

No Credit Score

FHA loans are different than subprime loans. In basic terms, to get an FHA loan you must have verified employment, income, and assets. Savings are great. You must be able to show that you can pay your mortgage and that you’re financially responsible. As the FHA explains:

“Generally,” says HUD, “to be eligible for an FHA loan, you must have a valid social security number and have lawful residency in the United States and be of a legal age to sign on a mortgage in your state. Lenders will verify income, assets, liabilities, and credit history for all parties on the loan. With an FHA loan, you cannot take an ownership interest in a property without qualifying for the loan. FHA’s mortgage programs do not typically have maximum income limits for qualifying, although you must have sufficient income to qualify for the mortgage payment and other debts. Income limits may be present when qualifying for down payment assistance or other secondary financing programs (including those funded by HUD) that may be used in conjunction with an FHA loan. FHA does not have minimum credit score requirements, although past credit performance serves as the most useful guide in determining a borrower’s attitude toward credit obligations and predicting a borrower’s future actions.”

Once you qualify for an FHA-insured loan you’re getting a better loan product than the typical subprime or ALT-A mortgage. With the FHA there’s no prepayment penalty allowed and no surprise interest-rate hike. Interest rates are generally much lower. You’ll need 3.5 percent down from your own pocket or in the form of a gift and you’ll also need closing costs, but these are reasonable hurdles.

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One Response to “FHA Versus Subprime: Why They’re Different”

  1. Nathan Reynolds Says:

    I 100% agree that Sub prime loans should never be compared to FHA loans. I have owned a successful mortgage brokerage for nine years and survived the storm by adapting to the ever-changing lending practices and becoming an FHA approved lender.

    FHA guidelines as defined by HUD could have prevented our current mortgage crisis and could have possibly even been a substantial component of rectifying the problem created by Sub prime loans, except for one small problem…. the Banks!

    When my office began offering low “fixed” rate FHA mortgages we successfully provided relief to 100′s of homeowners. I know this for a fact because by tracking the loans we have originated, there is less than a 3% default rate for a period of almost 3 years now.

    March 15th 2008 almost every lender started requiring Fico scores of a minimum of 580. And now that has minimum score requirement has risen to a 620 Fico score and even this score comes with risk based hits to the yield spread premium thus making the lowest rates unattainable.

    I recently spoke at a Foreclosure Education Summit and had the opportunity to speak with a representative from HUD who informed me she wouldn’t be surprised if lenders increased the minimum to a 680 Fico before years end!

    Thousand of distressed homeowners who have the household income to meet all the criteria for a new lower fixed rate FHA mortgage are not being given a chance to succeed because lenders have strictly enforced this minimum Fico score requirement, contrary to the underwriting guidelines for FHA loans.

    In closing FHA is a tremendous program but the Banks have corrupted its effectiveness.

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