Ah, the continued plight of the American mortgage system. While each year millions of homeowners finance and refinance real estate with few problems, the system is increasingly fraught with new complexities and potential pitfalls. Updates are constantly needed to keep up with a number of outside factors and trends. Without change, the system would increasingly be impacted by risk, fraud, and losses — factors which would result in fewer originations and higher rates. And so, the lending industry needs to be ready for anything.
It may seem difficult to believe that the mortgage system is stressed in any significant way. All of the traditional fundamentals appear to be positive. For instance, foreclosures — the most obvious measure of industry issues — were at a 13-year low in 2018 according to figures from ATTOM Data Solutions. ATTOM reports there were foreclosure filings — default notices, scheduled auctions, and bank repossessions — on 624,753 U.S. properties last year. And, despite all of the paperwork, many of these distressed properties were never actually foreclosed on.
The reason is that home values have been rising in most markets. The National Association of Realtors (NAR) says median existing home values reached $249,500 in February — the 84th straight month of year-over-year gains. With rising prices, some distressed owners can simply sell in the open market for enough to cover the debt — and many do! In 2018, says ATTOM, only 230,305 properties were actually foreclosed on.
Interest rates are also looking very positive for homebuyers right now, averaging 4.54 percent in 2018 according to Freddie Mac, well below the long-term average of 8.08 percent going back to 1971. By late March 2019, the big GSE said weekly rates for 30-year fixed-rate financing had fallen to 4.06 percent, down almost half a percent from the 2018 average.
In effect, it’s very difficult to see the growing stresses in the underwriting process because the system is now so successful. However, success masks the reality that low rates and rising prices are not guaranteed. They can come and go as the economy evolves.
And the economy, as we all know, always evolves.
“The U.S. economy has reached an inflection point, with the consensus forecasting real GDP growth to slow from 2.9% in 2018 to 2.4% in 2019, and to 2.0% in 2020,” said Kevin Swift in March. Swift is president of the National Association for Business Economics (NABE).
So, what are some of the factors and trends currently happening that are likely to impact the way lenders do business moving forward? Let’s take a look.
Ability to Repay
Federal rules as well as common sense tell us that lenders must verify the ability of borrowers to repay residential mortgages. While there are exceptions for such things as open-end credit plans, timeshare plans, reverse mortgages, and temporary loans (a loan for 12 months or less), the ability-to-repay rule is still the compliance gold standard.
Lenders take this stuff seriously, which may explain why the typical loan application vies with “Gone With The Wind” in terms of length and heft.
“With the size of an average mortgage loan at more than 500 pages — and hundreds of different document types — the labor-intensive and costly processing methods used in the past are no longer possible for banks that want to compete,” says ZIA Consulting.
What file size reflects is a serious effort to verify borrower claims. This added bulk, while necessary, is certainly an application problem. But bigger issues lurk beneath the surface.
What is Gross Income, Really?
All lenders generally treat income the same way. They check how much you earn each month before taxes. They can then see if it’s possible to “gross up” income for qualification purposes.
While the expression “gross up” may not sound especially alluring, it can be a huge benefit to mortgage applicants. It means that such things as child support, tax-exempt interest, and business depreciation can be added to taxable earnings to create a larger qualifying income.
For example, if you report $90,000 in yearly income before taxes and receive $1,000 in child support, the lender will review your mortgage application as if you earned $102,000 a year ($1,000 x 12 = $12,000 plus $90,000).
Grossing up can make a big difference for mortgage borrowers. The reason involves the debt-to-income ratio (DTI), a measure used to see if applicants qualify for financing. Lenders don’t want to provide mortgage financing to borrowers with big debts and excessive monthly payments. For example, lender Smith might be okay with borrowers who devote no more than 43 percent of their gross monthly income for recurring monthly debts such as housing costs, auto payments, student loans, and credit card bills.
Using the 43 percent standard, if you earn $90,000 a year, you therefore have an average household income of $7,500 a month before taxes. Allowable debt payments amount to $3,225 ($7,500 x 43%). However, if you earn $102,000, the picture changes. Now you have a gross monthly income of $8,500 and 43 percent of that is $3,655.
A bigger income allows you to have larger monthly debt payments and still satisfy lenders. This has become an increasingly important issue as consumer debt levels have soared. The Federal Reserve Bank of New York reports that total household debt reached $13.54 trillion in the fourth quarter.
“The total,” said the New York Fed, “is now $869 billion higher than the previous peak of $12.68 trillion in the third quarter of 2008 and 21.4 percent above the post-financial-crisis trough reached in the second quarter of 2013.”
One result of growing debt loads is that the HUD recently announced new and tougher FHA standards. Here’s why:
- Almost 25 percent of all FHA-insured forward mortgage purchase transactions in fiscal year (FY) 2018 involved mortgages where the borrower had a DTI ratio above 50 percent, the highest percentage since 2000.
- The average FHA borrower had a 670 credit score for FY 2018, the lowest average since 2008.
- There have been a growing number of applications with credit scores of less than 640 combined with DTI ratios greater than 50 percent.
- In FY 2018, 60 percent of all refinances were cash-out financing, meaning less equity is available to offset losses in a foreclosure situation.
To reduce risk, the Federal Housing Administration (FHA) is going back to a rule abandoned in 2013. For borrowers with credit scores below 620 and DTIs above 43 percent, the government will now require manual underwriting. The likely result will be fewer FHA originations and that will translate into reduced home sales.
In the wider market, we may also see an increasing use of dual-approach mortgage underwriting, the use of both automated systems as well as manual underwriting.
“One of the primary beneficiaries of non-agency, aka ‘non-QM’ lending, is borrowers whose income is not ‘typical or customary,’” Ray Brousseau, President at Carrington Mortgage Services, told Housing News Report. “These borrowers often have good credit and assets, but their income is considered non-traditional. They’re often self-employed, and although their bank statements support positive cash flow and the ability to repay, it’s hard to document using traditional approaches (1040s, W2s, etc.). Hence the advent of ‘bank statement’ non-agency programs that allow these borrowers access to financing through non-agency bank statement programs. These have proven to be extremely popular, and they’re manually underwritten.”
Is Gross Income the Right Measure?
Gross income has always been the main application standard but that’s likely to change as a result of tax reform.
Under tax reform, there were several major changes to the system.
- The standard deduction for those married and filing jointly went from $12,700 in 2017 to $24,000 in 2018.
- Mortgage interest remains deductible for as much as $750,000 in new first and second-home real estate debt, down from $1 million.
- State and local taxes (SALT) remain deductible, but there is now a $10,000 limit on combined property taxes and state and local taxes.
How do these changes impact the lending process? Two results stand out:
First, most borrowers will elect not to write off mortgage interest and property tax costs. Only four percent of households will claim itemized deductions, down from 21 percent under old rules according to the Tax Policy Center. Effectively, the cost of homeownership will rise in most cases while the distinctions between owning and renting will narrow.
Second, the value of income will change, depending on where you live. This very much impacts the concept of qualifying borrowers on the basis of gross income.
Prior to tax reform, such things as mortgage interest, property taxes, and state income taxes were commonly deductable, but now — with a larger standard deduction — the value of itemizing for most borrowers has fallen to zero.
Imagine that two married couples each have a gross annual income of $120,000. They’re alike in every way except for where they live. Living in Los Angeles, the couple will pay $8,004 in California state income taxes whereas in Florida, Texas, Wyoming, Washington, South Dakota, Nevada, and Alaska, the tax bill is zero. There is no state income tax in these jurisdictions.
The couple in the no-tax states has an additional after-tax, income. Why is that money – which is both real and spendable – not used to gross up the income for borrowers in Florida, Texas, etc? How is it any different from child support or business depreciation?
There is, in fact, a way to capture the blessings of lower tax costs. The Department of Veterans Affairs (VA) requires lenders to look at residual income (the cash left over after expenses) when qualifying borrowers.
“The VA’s residual income guideline offers a powerful and realistic way to look at affordability and whether new homeowners have enough income to cover living expenses and stay current on their mortgage,” says Chris Birk with Veterans United. “Residual income is a major reason why VA loans have such a low foreclosure rate, despite the fact that about 9 in 10 people purchase without a down payment.”
“In the end,” says Carrington’s Ray Brousseau, “residual income is critical. It’s what’s left that the family is expected to be able to live on. Residual income is an important characteristic when measuring ability to repay.”
The VA approach works extremely well. In the fourth quarter, according to the Mortgage Bankers Association (MBA), the non-seasonally-adjusted foreclosure starts rate stood at .19 percent for conventional loans with either 20 percent down or backing with private mortgage insurance, .55 percent for FHA-backed financing with as little as 3.5 percent down, and .28 percent for VA loans which are readily available with zero percent down.
We’re going to see the wider use of residual income. But that does not mean the gross income standard will melt away. Instead, it will increasingly make sense to reduce origination risk and qualify applicants on the basis of both gross income and residual income.
What Defines Employment?
A key measure of borrower finances is very simply the fact that they have a job. Lenders generally like to see a two-year history of employment at the same job or in the same field. But, how can this standard apply in an era when more and more of us are becoming gig workers?
“Broadly defined,” said Gallup in a 2018 study, “the gig economy includes multiple types of alternative work arrangements such as independent contractors, online platform workers, contract firm workers, on-call workers and temporary workers. Using this broad definition, Gallup estimates that 29 percent of all workers in the U.S. have an alternative work arrangement as their primary job. This includes a quarter of all full-time workers (24 percent) and half of all part-time workers (49 percent). Including multiple job holders, 36 percent have a gig work arrangement in some capacity.”
The common understanding of employment — 40 hours a week plus benefits — is giving way to the gig economy. We are increasingly a nation of freelancers, where more and more of us work independently, share jobs, or have multiple occupations. Corporations, in turn, love the new economy. With gig workers, businesses do not have to underwrite payroll taxes, or offer health insurance, paid vacations, or retirement plans to non-employees.
Gig work allows companies to tailor work schedules to avoid idle time. This also means many part-time workers are “on call” even if they are not actually working. Without a defined schedule, it’s difficult if not impossible to have a second job even though the hours are available.
Gallup says we now have two gig economies and that “independent gig workers (freelancers and online platform workers) often enjoy the advantages of non-traditional arrangements, while contingent gig workers (on-call, contract, and temp workers) are treated more like employees without the benefits, pay, and stability that come with traditional employment.”
“Tech-mediated gig work,” according to the National Law Employment Project, “is the latest iteration of a 50-year-old pattern of workplace fissuring – the rise of ‘non-standard’ or ‘contingent’ work that is subcontracted, franchised, temporary, on-demand, or freelance. Gig companies are simply using newfangled methods of labor mediation to extract rents from workers, and shift risks and costs onto workers, consumers, and the general public.”
“By 2023,” says MBO Partners, “over half (52 percent) of the private workforce is forecast to have spent time as independent workers at some point in their work lives.”
We have long had independent contractors such as accountants and lawyers who are sole practitioners. What’s new and different is that the concept is spreading to fields where workers have traditionally been corporate employees.
The growing gig economy disrupts the old definition of employment. The problem is that, at this point, we can’t be sure that gig employment means steady and reliable future income. Case in point: a 2018 study by the JPMorgan Chase Institute found that between 2013 and 2017, earnings for freelance drivers fell 53 percent.
One can argue that much contingent freelance income — and thus the ability of such workers to borrow and repay — will face big challenges in future years. Here’s why:
First, there are few barriers to entry. Lots of people can become dog walkers or freelance drivers. You don’t need a license or a degree for many gig positions. The result is that increasing supply pushes down wages. Freelance drivers, according to the JPMorgan Chase Institute, saw monthly incomes fall from $1,469 to $763 between 2013 and 2017.
Second, in the longer term, new jobs will be added as a result of marketplace change while others will largely disappear. While the secretarial pool was killed off with the introduction of personal computers and milkmen were done in by supermarkets, a huge number of service jobs have been added to the economy.
Lyft, for example, may create more opportunities for programmers over time while reducing the need for drivers. As it explained in its recent IPO, “In the next five years, our goal is to deploy an autonomous vehicle network that is capable of delivering a portion of rides on the Lyft platform. Within 10 years, our goal is to have deployed a low-cost, scaled autonomous vehicle network that is capable of delivering a majority of the rides on the Lyft platform. And, within 15 years, we aim to deploy autonomous vehicles that are purpose-built for a broad range of ride-sharing and transportation scenarios, including short- and long-haul travel, shared commute, and other transportation services.”
Third, the practical reality is that in a slow down, the first workers to be released will be contingent employees. Full-time workers will be expected to pick up the slack.
So, what to do when a contingent gig worker applies for a mortgage? How should such income be counted? Should gig income be grossed down in the same way that non-taxable income can be grossed up?
There’s certainly work for lenders to do. Automated systems will need to be refined to incorporate new work patterns. Manual underwriting will become more common, not less. The need for job experience is likely to grow with gig workers, requiring at least a look back at three or four years of past earnings and not just one or two.
Is it Really a Prime Residence?
Across America, the nature of residential real estate is changing. For many homeowners, it’s not so residential anymore. Several million travelers stay with homeowners on any given night. Empty bedrooms as well as unused attics and basements are increasingly seen as income opportunities.
The hospitality industry is fighting back, demanding that local governments enforce ordinances which limit the competition faced by tax-paying hotels and motels. But the die have been cast: there are simply more homeowners than hotel magnates. Rather than fight short-term rentals, local governments are increasingly coming to terms with the big rental platforms. They’re taxing the revenue received by property owners. More and more, it’s okay to rent a room as long as you pay the local government.
According to Airbnb in 2015, “Home sharing is making it possible to take what is typically one of their greatest expenses — their home — to make additional income that helps them pay the bills. Policymakers are taking notice and acting to support home sharing and the middle class.”
While the connection between rental rates and tax collections is direct and obvious, there’s also evidence that, at least in some markets, short-term rentals are forcing up real estate prices and rental rates. This is good for owners, though not so good for buyers and tenants.
For lenders, the growth of home sharing raises two questions: what is being financed and should the borrower’s income be bumped up on the basis of potential short-term rental income?
Francois (Frank) K. Gregoire, an appraiser based in St. Petersburg and the four-time chairman of the Florida Real Estate Appraisal Board, told The Mortgage Reports in 2017 that, “a room rental situation, depending on the number of rooms, may shift the use of the property from single or multifamily to a business use, such as a hotel or rooming house.”
This new world of short-term rentals raises a number of questions for lenders:
- Is the property a prime residence or a riskier investment property?
- If the property is used for short-term rentals, has the income been declared for tax purposes?
- If the home has not been used for short-term rentals, can an appraiser use short-term rental data from nearby and like properties to create a valuation?
- Is the property insured for use as a short-term rental?
- If local ordinances or HOA rules ban short-term rentals, can the owners repay the debt if rental income stops because of a complaining neighbor or code violation crack-downs?
There are already efforts to create financing options for short-term rental properties. “Hosts in the U.S.,” says Airbnb about its financing initiative, “will be able to work with participating lenders to recognize Airbnb home sharing income from their primary residence as part of their mortgage refinancing application. The three mortgage lenders in the initiative are Quicken Loans, Citizens Bank, and Better Mortgage.”
No doubt short-term rental income will be increasingly accepted for mortgage applications, along with a proper accounting of the costs required to operate such facilities.
The Question of Shared Equity
No doubt other loan programs for short-term rentals will become available if only because the market for shared-income properties is large and growing. But, while the market is attractive, it will require careful underwriting to ensure that residential financing is not being provided for investment properties or for borrowers who cannot afford to finance without rental income.
Or, maybe we need to look at this differently. Affordability is a big issue for many borrowers, especially first-timers. Research by ATTOM Data Solutions found in March that median-priced homes are not affordable for average wage earners in 71 percent of US housing markets. Many would-be buyers are being frozen out of the marketplace. But, if you can’t buy a home outright, perhaps it makes sense to buy part of a home.
Looking forward, we are likely to see an increase in shared equity arrangements:
- A property will have both a resident owner and a non-resident investor.
- Each owner will be able to potentially deduct their portion of the mortgage interest and property taxes. In addition, the investor will be able to deduct a portion of the depreciation and repairs. In practice, the resident owner will be unlikely to itemize real estate write-offs while the investor will have business deductions.
- The property will offer short-term rentals.
- The resident owner will essentially act as an on-site manager.
- The income from the short-term rentals will offset ownership costs for both the resident and investor owners.
- If property values rise, the resident owner will gain equity that’s unavailable to renters. If property values fall, some of the loss will be absorbed by the investor.
The Changing Climate
Climate change is a big issue today. Is it caused by nature, human activity, or both? Regardless of the answer, the reality is that climate change is here. Melting glaciers, rising seas, stronger hurricanes, “king tides” in Miami, flooded cherry trees along DC’s Tidal Basin, floods in Nebraska, massive hurricane damage in Puerto Rico, and huge fires in California are all real.
Does climate change impact lending? You bet it does!
The most immediate climate-related challenge faced by lenders is on Capitol Hill. Lenders will originate mortgages in high-risk flood zones on the condition that borrowers maintain proper insurance. For most borrowers, this means participating in the National Flood Insurance Program (NFIP). Unfortunately, the program is so broke that in 2017 Congress forgave $16 billion in NFIP debt owed to the Treasury. As this article is written, the program has been re-authorized, but only until May 31st.
“Congress must now reauthorize the NFIP by no later than 11:59 pm on May 31, 2019,” explains the Federal Emergency Management Agency (FEMA). While it would make sense for the program to be extended until September 30th, the end of the government’s fiscal year, there’s no requirement that Congress “must” do so.
The NFIP is riddled with problems. The most basic is that, with changing weather patterns, we’re not so sure which areas flood and which don’t.
“Even if you live outside a high-risk flood zone, called a Special Flood Hazard Area, it’s a wise decision to buy flood insurance,” according to FEMA. “In fact, statistics show that people who live outside high-risk areas file more than 25 percent of flood claims nationwide.”
As much as anything, this is an indictment of the federal flood mapping system, a system which appears to miss a lot of potential flood zones.
Mark Gibbas, President and CEO of WeatherSource.com, notes that changing weather patterns are a matter of concern both for mortgage lenders and insurance providers. According to Gibbas, a Task Force on Climate-Related Financial Disclosures (TCDF) has been formed.
“The TCDF is working to provide a framework for how lenders and borrowers will develop safeguards for doing business in a changing climate,” Gibbas told the “Housing News Report.” “This work is being done mostly at the big banking level, but it will trickle down to mortgages.”
We’re now beginning to see loan applications falling through in certain geographic areas because of climate change.
“This,” says Gibbas, “has happened a bit, mostly due to the influence from the insurance side. What has happened is insurance companies are, in some cases, refusing to insure a property after multiple claims have occurred. The lack of insurance then stalls the mortgage process. I have not seen any cases where mortgage companies refuse to underwrite the loan on their own.”
He adds, “I’m also aware of new technologies coming to market that will provide insurance and/or mortgage companies the ability to drill down on to a property to get details of past weather events and weather event probabilities. With these new tools, mortgage companies will gain insight into how to prioritize their lending opportunities.”
Institutional investors are already considering climate change when evaluating financing and purchase options. No doubt the same is true, less formally, among residential buyers.
“Climate change and, more particularly, rising sea levels are especially urgent issues along American coastlines,” according to the law firm of Hinshaw & Culbertson LLP., which in April organized the Third Annual Sea Level Rise & Climate Change Conference. “In the next twenty-five years, absent radical remediation and technical breakthroughs, the sea level along the coasts is anticipated to rise by up to three feet (0.91 meters), inundating major portions of the cities of New York, Miami, and coastal areas worldwide. Rising sea levels will result in major changes not only to developments and infrastructure (privately-owned structures, roads, utilities, etc.) but also to federal, state, and local laws and regulations which affect developments and infrastructure and their owners and investors. Also affected will be the insurers that will be dealing with claims and trying to create the next generation of underwriting guidelines and policy coverage. Other relevant and highly probable multi-hazard risks with climate change include greater occurrences of tropical storms and hurricanes, flash flooding, droughts, land subsidence, forest fires, and heat waves.”
The bottom line: underwriting guidelines will need to be revised in the face of climate change. The National Oceanic and Atmospheric Administration already has a “Sea Level Rise Viewer” online which shows which properties will be inundated by rising water levels.
In 2018, natural disasters produced $91 billion in damages, a sum property insurers cannot ignore. Whether the issue is floods, winds, or wildfires, in the end, mortgage underwriting standards will have to evolve. The practical effect is that more and more areas will face “managed retreats,” a polite term that increasingly will mean mortgage financing is unavailable.
As we look into the future, changes abound. Just as home buying patterns, consumer preferences, employment trends, and even the weather continues to change, so must the mortgage industry’s approach to mortgage applications.