Fannie Mae's Tight Lending Guidelines

How Fannie Mae's New Mortgage Qualification Rules May Harm Home Sales

Editor’s note: The following was written by Fernando Paez, an experienced mortgage professional and writer who lives and works in California and is a regular contributor to Bills.com.

Borrowers are feeling the squeeze since Fannie Mae imposed new, much stricter guidelines for mortgage underwriting in December 2010. Even highly qualified borrowers with 740+ credit scores, steady employment, high income-to-debt ratios, and substantial equity may find themselves under the microscope with these new, tight limits.

The new guidelines are significant because approximately 90% of mortgage loans sold in the US conform to Fannie Mae’s specifications, and Fannie Mae buys approximately 28% of mortgages today. The new guidelines have a tremendous impact on the mortgage market, both because of Fannie Mae’s market influence and policy changes themselves.

Strict lending guidelines protect home buyers and lenders alike because well-qualified borrowers are less likely to default on their mortgages, which cuts lenders’ costs. However, if fewer buyers qualify, fewer homes will be sold, which will drive down appraised home values and cause more homes to be upside-down in value and drive more homeowners into strategic default. Lower home values also make it difficult or impossible for otherwise qualified homeowners to take advantage of low interest rates and refinance their mortgages. The new guidelines will create a domino effect throughout the real estate market.

This article outlines Fannie Mae’s new guidelines and their expected impact on the market.

Condominiums

Many condo owners find it increasingly difficult to sell their properties due to Fannie Mae’s new condo rules. In theory, these rules protect buyers and lenders, but mortgage professionals and real estate agents I have spoken to say the new guidelines are slowing condominium sales significantly.

Here are three particularly difficult new condo rules:

• Fannie Mae will reject any loan application for a condo loan where more than 15% of current condo owners are delinquent on their HOA fees.
• 70% of the units must be sold or under contract for the condo building to be "certified."
• If the building has more than 25% commercial space, no one owner can own more than 10% of all units in the building, including the sponsor (builder/project owner). We have run into this restriction in Manhattan where the rule disqualifies conforming mortgages in most high-rise condo towers.

These guidelines may drive developments into bankruptcy. If buyers cannot get a loan, then how can condo developers sell 70% of their units? It is definitely a Catch-22 that needs closer examination. These restrictions could result in a massive glut of unsold condos on the market, which will, in turn, lower values.

Cash-Out Refinances

Homeowners cannot refinance and take cash out of a property until they have been on the title for six months. This is frustrating if the homeowner wants to capitalize on declining rates, now qualifies for a lower rate than he or she found in a purchase money loan, or needs cash for home improvement.

Once a homeowner completes a cash-out refinance, he or she must wait another six months to qualify for another cash-out refinance. If the homeowner does a rate-and-term refinance, he or she can refinance right away, but with certain lenders only. This may cause many to miss out on lower rates as they become available.

It is understandable Fannie Mae now requires a seasoning period between cash-out refinances. One of the reasons many homeowners are upside down today is that some took too much equity out of their homes. This practice, coupled with false, over-inflated appraisals, led to an excessive inflation in housing values that helped create the price bubble that burst in 2008.

Qualifying for a Mortgage

Fannie Mae will reject home buyers with a debt-to-income ratio greater than 45%, down from 55%. Fannie will also reject anyone who has had a bankruptcy in the last seven years, up from five. Fannie requires a 5% down payment, although most lenders today ask for 10% down payment.

Borrowers may not pay off credit cards and reduce their debt-to-income ratio with the proceeds of a cash-out mortgage. In bygone days, if a homeowner’s debt-to-income ratio (DTI) was too high to qualify for a loan, they could take the proceeds of the loan (cash-out) from their home’s equity and pay off the credit cards in order qualify. No more. Fannie Mae’s guidelines now prohibit this practice.

It appears Fannie Mae is concerned that homeowners will deplete their equity by paying off their credit cards, and then in a short time rack-up their credit card balances again, putting the borrower at risk of foreclosure. The Fannie Mae appears to want borrowers to sweat when paying down their credit card balances, on the theory that a homeowner who works to cut their debt will not go back into debt as rapidly. The rule also insulated lenders by, in effect, requiring the homeowner to have more equity in their home.

On the other hand, if the homeowner has sufficient equity to pay off his or her credit cards, why should the lender not allow a cash-out mortgage to reduce the overall debt load? Doing so reduces a borrower’s outbound cash flow, making the mortgage loan more secure. We are talking about borrowers with great credit scores here and subsequently, very little risk of ever missing payments and getting into foreclosure. What Fannie Mae is saying to these excellent borrowers is, "You cannot manage your own finances. We therefore need to manage it for you." This appears to be a patronizing attitude to qualified borrowers with excellent income and credit.

Fannie Mae’s rule changes signal greater caution in mortgage qualifications. I expect if Fannie Mae changes the cash-out credit card rule, it will likely require the home buyer to close any paid-off credit card accounts. Closing an account with a long credit history harms a credit score, so this could create problems qualifying for a mortgage. Also, many borrowers are averse to closing accounts with accumulated mileage or bonus points, especially if they lose these hard-earned freebies.

Credit Scores

Fannie Mae now requires a minimum FICO credit score of 620 out of 850 to qualify for a loan. (The old threshold was 580.) Fannie Mae’s best pricing threshold is 740. This may not seem so difficult, but if you are applying for a loan with a 620 score, you will probably not get approved for the loan because the lender’s underwriting department will question each negative item on the report.

The underwriter will demand documentation from collectors showing the debts are paid. This type of documentation is tough to obtain from collectors, especially after the debt is paid.

Cash Out

If you pay off a junior mortgage such as a Home Equity Line of Credit (HELOC) during a refinance, Fannie Mae considers it a cash-out refinance, no matter how long you had the HELOC. This is a bit strange since many times homeowners will hang on to a HELOC for a long period of time without using it. Some private portfolio lenders, usually those that handle jumbo or non-conforming loans, do not have this requirement and will only consider these cash-out transactions if the borrower has taken cash from the HELOC within the past 12 months.

ARM Qualifying

When qualifying for a 3/1 or 5/1 ARM you have to qualify at the start rate plus two points. For example, if the fixed period note rate on a 5/1 ARM is 4.5%, then the borrower has to qualify their debt-to-income ratio at the much higher rate of 6.5%. For interest-only loans, borrowers will have to qualify at the fully amortized rate.

This guideline is relatively new and is intended to keep people from getting into short term loans that they will not be able to afford later once the fixed rate period is done. Fannie Mae does not want homeowners to default if rates jump during the fixed-rate period and are shocked when rates reset.

Short Sales

If a home buyer sold a previous home in a short sale, Fannie Mae will not write a loan for that person for 24 months. This rule strikes me as punitive in nature. If the prospective home buyer suffered no credit report damage from the short sale, has a consistent work history, and a sufficient down payment, I cannot see why Fannie Mae would otherwise care whether or not the applicant had a recent short sale.

Investors

Investors cannot buy more than five residential properties with Fannie Mae funds. This is another rule that does not make much sense. Investors usually buy properties for rentals or to flip them. Either the investor qualifies or they do not. Most investors are savvy and were not the source of most recent loan defaults. Any real estate investor that has survived the real estate crunch will have excellent credit and verifiable income, so once again it is another example of Fannie Mae telling a borrower, "You can’t manage your own finances on your own. You need us to tell you what to do."

In Conclusion

Fannie Mae’s strict lending guidelines are changing daily, and in some instances hourly. Work with an experienced and licensed loan officer to navigate the rules changes.

Paez has more than 12 years of experience helping homeowners and home buyers with real estate financing. Paez also has experience doing commercial loans and loans for developers. He writes extensively on real estate financing and other subjects for several blogs and Web sites.