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Friday, October 19, 2007

DAP for UberNerds

by Tanta on 10/19/2007 09:30:00 AM

Given the questions in the comments to yesterday's post on seller-funded down payment assistance (DAP), I thought I'd offer a very simplified example of what the issue is. Yes, this is simplified; FHA loan calculations are pretty complex, even though they aren't as complex these days as they used to be.

Currently, FHA requires a minimum cash investment from borrowers equal to 3.00% of the contract sales price. The effective LTV can still exceed 97% even with a 3.00% investment, because borrowers can finance a portion of allowable closing costs, including their up-front mortgage insurance premium (UFMIP), in the loan amount. (FHA borrowers with a base LTV of more than 90% also pay an additional mortgage insurance premium in the monthly payment of 0.50% annually.) The current UFMIP with 3.00% down is 1.50% of the loan amount.

The administration's proposed zero-down program would have UFMIP of at least 2.25% and a monthly premium of at least 0.55%.

FHA does allow the borrower's down payment to come from gift funds provided by relatives, employers, governmental agencies or true charitable organizations. The point here is that 1) these are supposed to be true gifts with no expectation of repayment, not disguised loans, and 2) they may come only from parties who do not have an interest in the transaction.

Property sellers may contribute up to 6.00% of the sales price to an FHA borrower without affecting the appraised value of the property, but this contribution may be applied only to closing costs and points, repairs, etc., not to the minimum investment (i.e., the down payment). If the seller contributions exceed 6.00%, the excess amount is subtracted from the sales price of the property (as a "sales inducement"), which lowers the maximum loan amount accordingly. HUD has never allowed property sellers to directly provide funds for the minimum 3.00% down payment.

The seller-funded DAP programs get around this problem by having the property seller contribute the down payment funds to a "nonprofit" company which then "gifts" the funds to the borrower. Sellers are generally charged a fee of at least $400 for "processing" their contributions. Every reputable study (non-industry-sponsored) of the resulting loans (like this one) shows that 1) the sales prices of the properties are inflated by the amount of the "assistance" and that 2) the loans default at least twice as often as those with bona-fide gifts from a disinterested party. Even worse, because they are processed with the standard UFMIP charged to loans with a 3.00% down payment, this additional risk is not offset by a higher premium.

Here's how it works. First, here's a "typical" FHA loan with a 3.00% down payment (we'll assume that the seller pays closing costs other than UFMIP in cash, just to keep things simple):

  • Original list price: $100,000
  • Contract sales price: $100,000
  • Appraised value: $100,000
  • Required borrower down payment: $3,000
  • Base Loan Amount: $97,000
  • UFMIP: 1.50% or $1,455
  • Total loan amount: $98,455
  • Effective LTV (based on original list price): 98%

Here's how it works with a typical seller-funded down payment:

  • Original list price: $100,000
  • Contract sales price: $103,505 (list price plus $400 processing fee, divided by 0.97)
  • Appraised value: $103,505 (or any amount above that, as LTV is calculated on the lower of appraised value or contract sales price)
  • Required borrower down payment: $3,105 (provided by the seller via the DAP)
  • Base loan amount: $100,400
  • UFMIP: 1.50% or $1,506
  • Total loan amount: $101,906
  • Effective LTV (based on original list price): 102%

If the DAP loan were treated as the same risk as the proposed zero down program, you would get UFMIP of 2.25% or $2,259, resulting in a total loan amount of $102,659 and effective LTV of 103%. That would actually produce a higher loan amount than a true zero down program would, because of that $400 "processing fee" to the "nonprofit" (zero down base loan amount of $100,000, UFMIP of $2,250, total loan amount of $102,250, or $409 less than the "assistance" loan).

What happens if the appraiser refuses to play along with this scheme? Well, that would create a problem: the maximum loan amount is calculated on the lesser of the sales price or appraised value, and so the borrower could not borrow enough to pay the inflated sales price if it were greater than the appraised value.

What if the seller simply reduced the contract price by $3,505 (the cost of assistance plus processing fee)?

  • Original list price: $100,000
  • Contract sales price: $96,495
  • Appraised value: $100,000
  • Required borrower down payment: $2,895
  • Base Loan Amount: $93,600
  • UFMIP: 1.50% or $1,404
  • Total loan amount: $95,004
  • Effective LTV (based on original list price): 95%

The problem with that last scenario, of course, is that the borrower still has to come up with a down payment. The whole purpose of seller-funded DAPs is to get borrowers with no funds into loans, not merely to facilitate legitimate seller concessions.

Does it really matter whether gift funds come from an interested party? Yes, it does. A party without an interest in the transaction has no incentive to induce or persuade the borrower to pay more than the fair market value of the property; in fact, a distinterested party has an incentive to assure otherwise, since the lower the appraised value and contract sales price, the less the third party has to contribute. Government agencies and true nonprofits who provide such assistance are known for being mean and skeptical reviewers of appraisals and sales contracts, you see. (They also generally have income limits and other rules designed to keep speculators and other non-needy folks out of their programs.) Seller-funded DAPs avoid all that "red tape" and "excessive processing time."

I personally have never had any enthusiasm for the proposed zero down FHA program. But even it is better than the DAP scam. Those who claim that DAP loans provide a benefit to borrowers without funds are making no sense even if you grant that making loans to people without even minimal skin in the game is a good idea: the DAP programs simply keep contract sales prices inflated, channel fees into the pockets of "nonprofits" who provide no other service than laundering money, and result in lower insurance premiums than FHA should be getting for loans with riskier profiles. If you care at all about the long-term survival of the FHA program, you would be doing everything you can to protect it from this kind of damage.

By their own logic, the Congressional defenders of DAPs should be pursuing the zero down program, and/or funding for true nonprofits and local governments who provide forms of down payment assistance that don't inflate sales prices and that offer real, useful homebuyer counseling services. One of the arguments for DAP is that it is available for borrowers who aren't lucky enough to have family, an employer, or a local agency or true nonprofit who can provide gift funds. That's right: if you aren't lucky enough to receive a true gift that enables you to buy a market-priced property, you can be thrown to a bunch of sharks who will provide you with a "gift" with a hidden price tag. This is a good thing, since owning an overpriced home and making the higher payments is, I guess, a major blessing.

Supporting DAPs means supporting property sellers--particularly but not limited to builders and developers--and the "entrepreneurs" who form "nonprofits" to extract fees from naive homebuyers, not to mention loan originators who pocket higher commissions, with the risk being carried by government insurance. It is, precisely, the kind of sleazy, conflict-ridden, self-serving "initiative," overtly "faith-based" or its sort-of secular equivalent "dream-based," that thrives in an environment where regulation is dismantled or unenforced and "government" is bashed with one hand and milked with the other. It is an "innovation" just like plainer, older-fashioned forms of money-laundering are "innovations." It takes a profound ideological blindness to march behind the DAP banner in the name of "helping first time homebuyers."