There are a certain number of real estate agents who like FHA loans because they think it means the buyers will be suckers and will overpay. The FHA program is generally targeted at unsophisticated first time buyers to help them get into a home. The United States government loves home buyers because they turn into voters to protect their property interest. So they give lots of breaks to them - First time homeowner credits, mortgage and real estate tax deductions on income tax, etc. FHA is specifically designed to low down payment and low credit score buyers.
Quite a while ago (I think it was after the 2003 Dotcom bubble burst But I'm not 100% sure on that) there was talk about tightening up low down payment loans. Barney Frank testified somewhere and said “But what about people who don't have 20 or 25% to put down on a house?” and my immediate thought was “those people probably shouldn't be homeowners then.” What followed was a boom in low down payment subprime mortgages. It is the general consensus that this caused the Great Financial Crisis and almost took down the entire world economy. Afterwards Frank said something like “perhaps there are people who shouldn't be homeowners and we wrongly push them into buying homes.”
https://seekingalpha.com/article/167151-barney-franks-bad-housing-loans
When anyone buys with less than 6% to 8% down payment they are essentially underwater as soon as they close. This is because closing costs (including real estate brokers commissions) on real estate are very high. Coupling this with low credit scores makes for some risky business unless we are sure prices are increasing.
Banks use an Underwriting process to qualify both the borrowers and the property to insure there won’t the issues with the collateral. Credit checks, asset checks, appraisal, etc. Various programs to make it easier to get loans usually do so by chipping away at the underwriting process. For example you can see in The Big Short they talk about NINJA loans which were “no income, no job, and no assets.” While that is the extreme there are lesser shades of diminishing Underwriting. FHA Streamline refinance does this by skipping paperwork and sometimes even an appraisal. This helps get the loan but increases risk for both the lender AND THE BORROWERS.
I’ve been dealing with foreclosures for 40 years and a major precursor is cash out refinancing. Part of having a larger down payment is having the purchaser with skin in the game. Once an owner doesn’t have their own money in a deal anymore they are far more likely to walk away. While it is generally accepted that the GFC was kicked off by subprime mortgage defaults, in the Foreclosure Crisis which followed there were more Prime mortgages where the owners strategically defaulted and walked away because they had negative equity than subprime borrowers.
https://www.nber.org/digest/aug15/us-foreclosure-crisis-was-not-just-subprime-event
Here is a somewhat convoluted example:
You have two people who own the exact same house right next door to each other. The first one bought the house for $500,000 put down $100,000 and took a $400,000 mortgage. The market went up to $1.5 million So they refinanced and got a $1 million mortgage pulling out their original down payment plus $500,000 in profit.
The second buyer bought when the house was at the $1.5 million value. They put down $500,000 of their own money and took out a mortgage for $1 million.
At some point the market crashes and the home is worth only $900,000. They both have a $1 million mortgage and thus are both $100,000 underwater. But which one is more likely to walk away? The one who thinks “hey I already got my $100,000 down payment back plus $500,000 in profit” or the one that thinks “I still have half a million dollars of my harder and cash in this deal I better hang on”?
So when you have an FHA buyer to begin with and then let them cash out refinance It can really be playing with fire.
Quite a while ago (I think it was after the 2003 Dotcom bubble burst But I'm not 100% sure on that) there was talk about tightening up low down payment loans. Barney Frank testified somewhere and said “But what about people who don't have 20 or 25% to put down on a house?” and my immediate thought was “those people probably shouldn't be homeowners then.” What followed was a boom in low down payment subprime mortgages. It is the general consensus that this caused the Great Financial Crisis and almost took down the entire world economy. Afterwards Frank said something like “perhaps there are people who shouldn't be homeowners and we wrongly push them into buying homes.”
https://seekingalpha.com/article/167151-barney-franks-bad-housing-loans
When anyone buys with less than 6% to 8% down payment they are essentially underwater as soon as they close. This is because closing costs (including real estate brokers commissions) on real estate are very high. Coupling this with low credit scores makes for some risky business unless we are sure prices are increasing.
Banks use an Underwriting process to qualify both the borrowers and the property to insure there won’t the issues with the collateral. Credit checks, asset checks, appraisal, etc. Various programs to make it easier to get loans usually do so by chipping away at the underwriting process. For example you can see in The Big Short they talk about NINJA loans which were “no income, no job, and no assets.” While that is the extreme there are lesser shades of diminishing Underwriting. FHA Streamline refinance does this by skipping paperwork and sometimes even an appraisal. This helps get the loan but increases risk for both the lender AND THE BORROWERS.
I’ve been dealing with foreclosures for 40 years and a major precursor is cash out refinancing. Part of having a larger down payment is having the purchaser with skin in the game. Once an owner doesn’t have their own money in a deal anymore they are far more likely to walk away. While it is generally accepted that the GFC was kicked off by subprime mortgage defaults, in the Foreclosure Crisis which followed there were more Prime mortgages where the owners strategically defaulted and walked away because they had negative equity than subprime borrowers.
https://www.nber.org/digest/aug15/us-foreclosure-crisis-was-not-just-subprime-event
Here is a somewhat convoluted example:
You have two people who own the exact same house right next door to each other. The first one bought the house for $500,000 put down $100,000 and took a $400,000 mortgage. The market went up to $1.5 million So they refinanced and got a $1 million mortgage pulling out their original down payment plus $500,000 in profit.
The second buyer bought when the house was at the $1.5 million value. They put down $500,000 of their own money and took out a mortgage for $1 million.
At some point the market crashes and the home is worth only $900,000. They both have a $1 million mortgage and thus are both $100,000 underwater. But which one is more likely to walk away? The one who thinks “hey I already got my $100,000 down payment back plus $500,000 in profit” or the one that thinks “I still have half a million dollars of my harder and cash in this deal I better hang on”?
So when you have an FHA buyer to begin with and then let them cash out refinance It can really be playing with fire.
