Remember the book and movie, The Perfect Storm? A series of unlikely weather events simultaneously occur at the same time to create the Perfect Storm. A weird analogy, but I'm predicting that homeowners eligible for loans guaranteed by the Federal Housing Administration (FHA) might jump on the FHA cash-out refi bandwagon -- one that doesn't exist … yet.
The Federal Housing Administration was created in Congress in 1934. For most of the latter half of the 20th century, loans guaranteed by FHA were the optimal choice for first time home buyers, due to its low down payment requirement and less stringent income and credit qualifications.
Over the last decade or so, FHA loans lost significant popularity due to the explosive growth of the product line offered through conventional mortgage financing, thanks to the growth of the secondary mortgage market, which packages loans and sells them as securities to investors. Simply put, many conventional products are better deals for first time home buyers.
But last October, FHA increased their cash-out refinance loan limits to 95 percent of the home's value, and I'm predicting a substantial increase in FHA refinance activity in 2006 and 2007.
Why would I make such a bold prediction in a market where interest rates have risen considerably and are poised to rise further? Let's take a look.
First, property values across the nation have increased substantially, and in some areas, skyrocketed. Since 2001, homeowners have been eager to cash in on their new found equity by increasing their mortgage debt. While rates were down, cash out refinances and new home equity lines of credit (HELOCs) ballooned.
Second, let's fast forward to the present day and we see that these popular methods of tapping into home equity are becoming out of favor. Home equity lines of credit (HELOCs) are usually tied to the prime rate. Only a year and a half ago, the prime was sitting at four percent. Today, thanks to the Federal Reserve's incessant rate hikes, the prime is now at 7.50 percent. Conventional fixed rate mortgages have risen as well, albeit not as dramatically, but enough to dampen demand.
Okay, if rates have risen across the board, why am I predicting an increase in FHA refinances? The key is loan-to-value (LTV). There aren't a whole lot of better alternatives if a homeowner is seeking 95 percent LTV cash-out financing. Let's take a closer look.
A HELOC allowing an LTV of 95 percent will carry a rate considerably higher than the prime rate. Expect the rate to be somewhere between one or two percent over prime. That's between 8.50 and 9.50 percent -- hardly a bargain compared to recent history. Moreover, these rates will move as the prime rate moves, which is predicted to continue to edge up.
Refinancing with cash-out to a 30 year conventional fixed rate is fine and dandy as long as you keep the LTV below 80 percent. A 95 percent cash-out fixed rate is going to be hard to find and very expensive. To make this deal even less attractive, the lender will require that the borrower pay private mortgage insurance (PMI) because the LTV exceeds 80 percent. Expect to pay somewhere near 1 percent for PMI, on top of the jacked-up mortgage rate.
The terms of a 95 percent FHA cash-out refinance aren't the greatest, but the program is quite likely the best option when considering the other alternatives. Consider the following:
- Unlike conventional loans, most lenders and brokers do not increase the rate or charge extra fees for a 95 percent FHA cash-out refinance.
- FHA offers 30 year fixed rates to 95 percent, making the deal more favorable than the adjustable, prime based HELOCs.
- FHA programs allow for higher "coupons," meaning a borrower can choose to take a higher rate and have some or all of the closing costs eliminated.
The downside of taking an FHA loan is the government mandated "Mortgage Insurance Premium," or MIP. MIP is largely the reason FHA loans have not been able to compete with conventional alternatives over the last decade. However, the ability to take a higher rate in exchange for lower closing costs offsets the cost of the MIP.
Credit card companies are responsible for the third event that's going to fuel these FHA refis. Under pressure from federal bank regulators, most large credit card companies are significantly increasing the minimum monthly payment on credit card balances. Most charge a minimum of two percent. By the end of the year, there's a good chance that the average minimum payment will double to four percent. If you can afford the increased payment, such a move is good news because the overall interest paid will drop dramatically.
But the payment shock could be difficult for a lot of folks, including homeowners. For example, the minimum payment on a $15,000 credit card balance would jump from $300 to $600 per month.
Financing $15,000 with a 30 year mortgage at 6.50 percent results in a $95 payment.
Taking consumer debt and converting it to mortgage debt can be a dangerous thing because it frees up room to jack up credit card debt all over again. It's important that debt is re-positioned, not increased. Taking expensive, high rate, credit card debt and converting it to tax deductible, low rate mortgage debt can be a good thing as long as future credit card charges are paid off monthly.
My guess is that homeowners with considerable credit card debt who suddenly face twice the payment may need to consider a larger mortgage to improve cash flow. For those needing 95 percent financing, an FHA loan is a reasonable alternative.
For the next column, I'll illustrate an FHA cash-out transaction and highlight some advantages and pitfalls. Stay tuned.
