FHA Loans: What is “Investor Overlay,” and Why it’s Important

by Karen Lawson
March 2nd, 2010

Changes to FHA guidelines are scheduled to become effective with FHA case numbers issued on April 5 and after. These changes are expected to reduce FHA risk and will likely make it more difficult for some borrowers to qualify for FHA home loans. Here are the changes impacting borrowers depending on FHA mortgage loans for buying and refinancing their homes:

  • Seller contributions reduced from 6% to 3%: This reduces the amount of buyer closing costs eligible for payment by sellers by half, and will require borrowers to contribute more cash at closing.
  • Up front mortgage insurance premium (UFMIP) raised: The UFMIP will increase from 1.75% of base mortgage loan amount to 2.25%.
  • FHA seeking Congressional approval to raise annual mortgaeg insurance premium: The annual mortgage insurance premium  (MIP) is pro-rated monthly and added to the monthly mortgage payment. FHA is seeking approval for raising the annual MIP so that it can transfer some of the UFMIP to the MIP, which would reduce the cash contributed  by borrowers at closing.
  • Borrowers with FICO credit scores below 580 required to make 10% down payment: In response to legislative pressure to raise down payment requirements, FHA conceded by focusing on borrowers with little or poor credit. The majority of FHA borrowers have credit scores in the mid 600′s and above, so this development is not viewed as critical for most FHA loan applicants.

FHA Guidelines: Lenders Playing by Whose Rules?

In addition to tighter FHA requirements, borrowers may face a phenomenon called “investor overlay.” Think of the relationship between federal law and state law; states have some leeway in legislating according to their particular needs. Although FHA establishes guidelines, some mortgage lenders may “overlay” their own requirements when approving mortgage loans. Some FHA approved lenders are requiring  higher credit scores for approving FHA loans. Such prudent underwriting practices may be a result of FHA pulling licensing from a number of lenders with high mortgage default rates, and lenders wanting to cover their backsides against poorly underwritten loans.  On the other hand, I question why mortgage lenders should be allowed to play by their own rules when participating in FHA home loan programs.

Bending FHA Requirements Could Lead to Trouble

As with failing to underwrite mortgage loans for creditworthiness, the idea of mortgage lenders imposing their own rules over FHA guidelines sounds like a recipe for trouble. Although FHA is reining in “rogue”lenders who increased the agency’s risk during  the subprime debacle, things could go the opposite way when lenders ”overlay” stricter underwriting criteria over FHA requirements.  The practice of arbitrarily mandating higher credit scores for FHA loans than FHA home loan programs require could set the stage for potential abuses of fair housing protections; let’s hope that any mortgage lender’s decision to require higher credit scores is based on its own uniform lending criteria, solid risk management principles, and not anything else.

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4 Responses to “FHA Loans: What is “Investor Overlay,” and Why it’s Important”

  1. Carl Pruitt Says:

    It’s a catch-22. Even though FHA loans are guaranteed by the insurance fund, lenders are still held responsible for defaults by both FHA and the secondary mortgage market. So lenders will likely choose simply not to offer FHA if they were not allowed to determine their own tolerance for risk and set their own guidelines which might be more strict than those a politicized bureaucracy might set.

  2. Karen Lawson Says:

    Good points, Carl. Thanks for sharing your thoughts. It’s true that if lenders are liable to having their policies held up to scrutiny, they should be allowed to apply such policies as prudently as possible.

  3. s2kreno Says:

    FHA’s relationship with lenders is complicated. On one hand, the agency wants to pursue its goal of encourgaging home ownership (whether that’s appropriate is better left for another discussion), and so it imposes fairly lax underwriting standard on the borrowers. However, it is more restrictive with its lenders. If a lender’s default experience is significantly higher than other lenders in its area, it can lose its FHA approval — even if every single origination was in full compliance with FHA guidelines. So if you are lender A, you figure that by imposing stricter requirements yoiu can keep your default % in the lower range for your location. Lender B sees this and responds with tighter guidelines to make sure it doesn’t have a high default % relative to Lender A’s. With FHA loans taking about 1/3 of the market share, that’s a chumk of business no lender wants to risk losing.

  4. Kevin Says:

    I see no mention of appraisal or other inspection reports being subject to investor overlay modification. Is this an area that isn’t permitted to be changed by FHA?

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