FHA “Short Refinance” — Is This The Way To Reduce Foreclosures?

Imagine that you have a mortgage and want to refinance to get a lower rate but the debt is greater than the value of the home. Imagine also that if you can refinance you can avoid foreclosure.

The government is now trying to address this scenario, something which is common across the country, especially for those who bought during the past few years with little or nothing down, have toxic mortgages or who live in communities which are in the eye of the foreclosure storm.

The basic idea of a so-called FHA short refinance is to replace current loans with new and shiny FHA mortgages. The government’s plan is great news for homeowners, if it will work. But will it work? And if the plan does work will the government get stuck with a lot of FHA mortgages that will soon default?

New Twist

The government established the Making Home Affordable plan in March 2009 with the intent of refinancing as many distressed borrowers as possible. As of June about 1.3 million homeowners had started three-month trial periods with lower monthly costs and nearly 390,000 borrowers now have permanent loan modifciations.

This is good news for a lot of people because the average monthly loan payment for those in the program fell from $1,422 to $838. This is a big savings, but the Making Home Affordable program cannot save all homeowners. There are borrowers who simply do not have the income to make even smaller monthly payments. Some 520,000 homeowners have started the trials and then washed out. For them, foreclosure almost certainly looms ahead.

But what if the program was changed so that more borrowers could be eligible?

The Treasury Department and HUD have now come out with a new program to extend FHA loans to borrowers with negative equity. Such “enhancements” are scheduled to begin in September.

How It Works

The new program says if you’re a homeowner and owe more than the house is worth the government has a deal for you: Refinance into a sane and solid FHA loan. Here’s what you need to qualify:

  1. You must be a homeowner (no investors allowed).
  2. You must be current on your existing mortgage and it cannot be an FHA loan.
  3. You must have a credit score above 500.
  4. The existing first lien holder must write off at least 10 percent of the unpaid principal balance.
  5. The refinanced FHA-insured first mortgage must have a loan-to-value ratio of not more than 97.75 percent of the property’s current value.
  6. If there’s a second mortgage, then the combined balance of the first and second mortgage cannot be greater than 115 percent of the combined loan-to-value ratio.

  7. You don’t qualify if you’ve been convicted of mortgage or real estate crime during the past 10 years (think of felony larceny, theft, fraud, or forgery; money laundering; or tax evasion).


Since the foreclosure crisis first began in 2007 the biggest question for lenders has been what to do with upside-down mortgages, situations where the property is worth less than the loan balance. Under the “enhancement” program, lenders would have to write off 10 percent of the existing mortgage balance to dump their loans.

For most lenders writing down principal is a huge problem. It’s asking lenders to be partners in property ownership when values fall — but not when values rise. Principal write-offs also impact lender books, representing large and messy losses.

In the case of the new government effort you’re just not going to see too many distressed homeowners getting new FHA loans. Two huge reasons stand out:

First, the borrower must be current on the loan. If the borrower has been making full and timely payments then the lender has no incentive to write-off a portion of the mortgage. The loan is performing, not distressed. To lenders, there’s no problem to “cure” and no reason to accept a loss. Since lender participation is voluntary you have to wonder why a lender would volunteer.

Second, in situations where there are two loans the junior lender under the program must allow the first loan to be refinanced and not move up to first place. But ask yourself: Why would a second lender agree to such an arrangement without compensation?

End Game

At this time the FHA program insures about 30 percent of all purchase money mortgages and 20 percent of all refinances. Given the rickety state of the housing market, and given common sense, nobody wants to do anything which would undermine the FHA program.

The enhancements announced by the government are unlikely to help many people because the requirements are self-contradicting and nobody wants the FHA to take on a bunch of high-risk loans. While the intention is good, the practical applications are remote and unlikely.

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