SANTA ANA, CA--(Marketwire - Dec 5, 2012) - "Supply and demand tell much of the rate story but not all," says Ray Brousseau, Executive Vice President with Carrington Mortgage Services. "Revised regulations are on the way and if new guidelines from Washington and overseas get too tight it's likely that borrowers will be faced with higher rates, demands for greater down payments and tougher qualification standards. Many borrowers who can now get mortgages may be unable to borrow if proposed new rules become reality."
How The System Works
A mortgage is both a way to finance homes and a financial instrument that can be bought and sold. We need mortgages because few people can buy a home for cash and we need financial instruments because they provide much of the cash that's used to create mortgages. Here's how the system generally works:
The Smiths want to buy a $300,000 home. They can put down 5% but the rest of the purchase is financed with a $285,000 loan from Lender Johnson. After closing, Johnson sells the loan into the "secondary" market, where mortgages are bought and sold. The Smith mortgage will likely be combined with thousands of other mortgages to create a mortgage-backed security (MBS).
- The Smiths can buy the property with little down because financing is available to them.
- Homeowners can sell properties because buyers have access to the mortgage marketplace.
- Lender Johnson gets cash from the sale of the loan, which can be used to create new mortgages for other homebuyers.
"Investors worldwide such as pension funds and insurance companies buy mortgage-backed securities," says Brousseau. "Money from MBS investors provides the cash that is used to provide a steady stream of new loans. In the end the secondary system market gives qualified borrowers access to mortgage financing regardless of where they live in the US."
In recent years many steps have been taken to strengthen the lending system. However, rulemaking is not complete and some worry that the final regulations will be too strict and could substantially limit access to mortgage financing.
For instance, Congress has passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. This legislation creates two important mortgage lending standards.
First, the new law establishes a "Qualified Mortgage" or "QM" standard. These rules say lenders can only make loans to residential borrowers who have the ability to repay the debt. Sounds good, but what if the final regulations say that only 27 percent of a borrower's income can be used to qualify for housing costs? That's far stricter than today's standard and would deny financing to many borrowers.
For instance, if borrowers make $5,000 a month only $1,350 could be used for the mortgage, property taxes and insurance under the proposed 27% standard. The same borrowers under today's FHA rules could set aside $1,550 (31 percent) of their monthly income for housing -- and as much as $2,050 (41 percent) under VA guidelines. Translation: Some borrowers will need more cash to buy a home if the new rule is approved or they will only be able to afford a less expensive property -- if they are able to buy at all.
"It's not just borrowers who will be impacted by such rules," notes Brousseau. "If loan amounts are restricted, it also means less demand and lower home values. Property owners will have less value when they sell and less equity when they refinance. It's also a problem for state and local governments because lower home prices also mean smaller decreased property tax revenues."
Second, the Wall Street reform legislation also establishes a "Qualified Residential Mortgage" (QRM) standard. The QRM rules say that only certain loans can be used to create mortgage-backed securities, which could limit the amount of capital available for lenders to write loans. And QRM rules may establish new guidelines calling for a minimum down payment of 10 or even 20 percent.
"Arbitrary minimum down payment requirements would lock middle-income families out of the mainstream market," said the Center for Responsible Lending. "Given median housing prices and incomes, it would take over 20 years for the average family to save a 10 percent down payment plus closing costs."
Also on the lending horizon is the Basel III banking standard. Basel III is a set of international rules that establish reserve requirements for lenders -- the bigger the reserve requirement the less money a bank has to lend in the form of mortgages.
"Efforts to limit risk are well within the bounds of financial common sense," says Brousseau. "At the same time, if reserve requirements are too strict, we'll quickly see higher mortgage rates, fewer loans, less real estate demand and falling home values. A major reason for financial reform will be defeated, and the housing recovery will stall if not reverse for years to come."
Supply and demand do tell much of the interest rate story but they don't tell the whole story.