MORTGAGE: FHA finally facing reality: Borrowers will need to put up more cash

The Federal Housing Administration has been focusing its efforts to shore up its finances on stricter rules for lenders, but in testimony before the House Financial Services Committee on Wednesday, Housing and Urban Development Secretary Shaun Donovan is expected to announce changes to rules for borrowers, requiring more skin in the game.

The change is needed because FHA reserves have dropped to $3.6 billion, or about 0.5% of the $685 billion in loans the FHA has insured. The law requires that the FHA hold 2% of its outstanding loans in reserve, but the agency can borrow from the U.S. Treasury without limit and without Congressional approval. So it can essentially become a black hole for taxpayers.

Changes expected to be announced at the hearings include:

• Borrowers will need to put more money up front. Right now borrowers can put down as little as 3.5 percent. One bill in Congress calls for that to be raised to 5%. Private lenders today require between 10% and 20%. Most want 20% unless your credit score is above 750.
• Borrowers may have to pay more in insurance premiums. Right now that premium is 1.75% of the loan value plus 0.5% or 0.55% per year.
• Sellers will be restricted by how much they can help the borrower. Right now a seller can pay as much as 6% of the home's value in closing costs. The maximum level is expected to be lowered to 3%.
• Borrowers may need better credit scores. Right now the score can be as low as 500. While that's the law, lenders don't usually accept scores that low. The FHA is expected to raise that minimum score. This may not be as noticeable as the other changes because most lenders do expect a higher score, but this change will prevent abusive lenders from lending to unqualified borrowers.

Requiring more cash up front could dampen FHA lending considerably, but with more skin the game borrowers are less likely to walk away from a property. Right now the agency backs about 30% of all loans for home purchases and 20% of all refinancings. Since private mortgage money is hard to get in the current market, borrowers have become very dependent on the FHA.

While these stricter rules will discourage borrowers and likely slow down what is already a struggling housing market, it's critical that the FHA shore up its reserves and stop the bleeding; otherwise, taxpayers will foot the bill.

By Lita Epstein DailyFinance.com December 2, 2009