In the past few months, we have felt HUD yanking insistently on the leash of of FHA underwriting.   We’ve all been wondering, in the absence of overt policy change announcements, what’s going on and more importantly, how will it affect FHA lending.  It’s already more challenging than ever.  Will it get tougher?  The answer appears to be a clear “yes”.

We feel the change in visceral ways.  First, many banks (but not all) increased their credit score requirement for FHA loans from 620 to 640.  Old timers will recall that up until last year, FHA loan had no credit score minimum at all.   Then, fees became an issue, with some banks capping or disallowing certain fees about which they had been previously unconcerned.

Back in May, HUD suspended Taylor, Bean, & Whitaker Mortgage Corp. the 3rd largest FHA loan originator in the country for concerns about fraud and questionable business practices and announced sanctions against 120 approved FHA lenders.

Now it appears that default rates may deplete FHA’s reserves to the point where taxpayers must be called upon yet again.  FHA loans have replaced subprime loans as the primary source of funds for cash-strapped home buyers.   But if FHA loan defaults require a tax payer bailout, then expect FHA lending to tighten considerably as legislators try to resolve yet another crisis in the making.

This is a repost of an article I wrote in March.  It came to light again because an agent I work with had a deal that hung up last minute over the issue of property taxes.  Here, with a few edits and updates, is  what I wrote:

You’re a shrewd home buyer.  You’ve waited patiently for prices to fall and interest rates have stayed down as well.  Now you’re in Contract, and the price is half of what the seller paid for it.  You won!  Good job.

It’s true, you have made a smart purchase.  But there is one little quirk in all this to which you need to pay close attention.

A Little Nostalgia

Remember the good ‘ole days when homes were appreciating in value?   Back then, each successive owner paid property taxes a little higher than the last. Why?   Because property taxes are reassessed after each sale and rise with values.  In lending, we always estimated the new tax amount based on the purchase price in order to establish the correct amounts for the escrow account.

In this market however, property values are falling. and property taxes should follow along, right?  Yes…eventually.  Remember, property taxes are established for a year at a time, and your purchase does not immediately alter the tax amount.  In fact, with all the activity, it seems to be taking the tax assessor’s office longer than normal to catch up and lower those taxes.

Between property tax appeals by homeowners and an active real estate market, California recently warned that until they are able to complete the reevaluation (and that could take up to a year), new homeowners must continue to pay the previously established property tax amount.  In many cases here in the Sacramento area, that’s several hundred dollars more per month than it will ultimately be.

The Effect on Qualifying

Following that ripple out to the edge of the pond, several things become clear.  First, because lenders are now requiring that borrowers qualify with the higher tax payment in their debt ratios, your debt-to-income ratios may now be too high and your approval worthless.   You may have to reduce the price or increase your down payment in order to qualify to buy that particular home.

Second, if you have a loan that requires impounds for taxes and insurance–FHA, VA, and conventional loans with less than 20% down– your actual monthly payment will be higher until taxes are corrected.  Lenders are insisting on this because they need to ensure that they have adequate money to pay the taxes when due.

Finally, especially at this time of year when lenders are requiring 8-9 months of property taxes at the close to put in the escrow account, this can substantially increase the cash needed to close.

To be sure, the payment part of this problem is temporary.  But you can also end up without a loan if you’re not careful.  In extreme cases, it can result in foreclosure.  I recently spoke with a retired gentleman who is losing his home because his lender had raised his payment from $1300 to $1900 to compensate for incorrectly calculated property taxes.  He couldn’t make the higher payment and the lender, refusing to work with him, had started the foreclosure process.

An Ounce of Prevention

To correct for this problem, check the seller’s current property taxes and use 1/12th of that number for the property taxes and impounds on your purchase.  And be diligent right through the close of escrow.  Despite my practice of using existing taxes, I have had escrow officers reinstate the incorrect numbers at the close of escrow.  So, make sure you can afford the higher payments, and plan to reevaluate each time you find a home you like to make sure your loan isn’t declined at the last minute because your debt ratios suddenly went tilt.