The Federal Housing Administration plans to make it tougher for borrowers to refinance a loan and take out cash as the agency tries to “limit its exposure to undue risk,” according to a letter that went out to FHA lenders this week. The decision comes at a time when defaults are rising in HUD’s flagship, FHA home loan insurance program, especially among borrowers who failed to make more than a single payment. The Washington Post reported recently that the quick loan defaults almost tripled in 2008 alone and more than quadrupled among FHA home refinancing.

FHA refinance loans now make up two-fifths of all the agency’s instant defaults, according to the Post analysis, and some lenders have singled out cash out refinance loans as especially risky. With conventional loans, many lenders now offer cash out mortgage only to borrowers with high credit scores and significant equity in their homes. The fear is that borrowers might otherwise take the cash and walk away from the mortgage.

Until now, the FHA has approved cash out refinancing for homeowners who have at least 5% equity in their properties and at least a one-year track record of on-time payments.  Starting with mortgage applications that FHA lenders receive April first, this type of mortgage refinancing will be restricted to borrowers with at least 15% equity in their homes.

The change will be temporary “while FHA further analyzes the housing and mortgage industry as well as its own portfolio to determine whether permanent measures should be taken,” said the letter, signed by departing FHA Commissioner Brian D. Montgomery.  The FHA does not lend money directly. It provides mortgage insurance for borrowers working with HUD-approved FHA mortgage lenders and uses the premiums to cover its losses.  The quick defaults suggest that some borrowers are taking out loans they do not stand a chance of repaying, raising questions about whether the abusive lending practices that helped topple the subprime mortgage industry are making their way into government-backed FHA lending.

The agency has come under increased scrutiny in the past years because its share of the mortgage market has shot up from about 2% three years ago to nearly a third of the mortgages made after the subprime market vanished and its loans became the only option for many borrowers who lack a hefty down payment or stellar credit.

But even before the FHA loan policy change, many lenders had moved beyond what the agency requires and instituted tougher qualifying standards for borrowers, especially those looking for cash-out refinance deals. Bank of America, which adopted tighter standards in the summer, yesterday applauded the agency’s decision.  “Safeguarding the FHA through this economic cycle is paramount to maintaining the liquidity FHA offers for home buyers today,” said Allen Jones, a government lending executive at Bank of America.

It becomes more and more evident that the government wants homeowners to be able keep their primary residence homes and weather the storms. Clearly they will need more cooperation from the mortgage lenders and investors that hold the FHA mortgage rates continue to benefit from Fed interest rate cuts.

How will Fed Rate Cut Help Homeowners with Mortgage Rates for Refinancing? 

Furthermore, Bernanke said that the interest rates borrowers pay under the program could be reduced from the current level of about 8%, which remains so high because it is hard to find buyers for FHA loan backed securities. To fund the rate reductions, he said, Treasury could buy up mortgage-loan securities bundled by government-sponsored loan securitizer Ginnie Mae, or Congress could choose to subsidize the rate.  Bernanke also announced that would support putting borrowers into home mortgages they could afford over the long haul.  Industry sources said Wednesday that Treasury is contemplating a plan to buy mortgage-backed securities to reduce 30-year fixed mortgage rates down to 4.5% from their current 5.5% level, but it appears this plan might be aimed at helping new homeowners, not distressed borrowers seeking mortgage relief from FHA home refinancing.  He also recommended a plan that would have the government share the cost if the loan servicer reduces the borrower’s monthly payment. Current government initiatives have encouraged servicers to lower borrowers’ payments, but the plans have offered little incentive to do so. Bernanke said this approach would increase the incentive, which would “improve the prospects for sustainability.”

Investors reacted enthusiastically to the U.S. government’s plans to spend $250 billion to buy stock in private banks. The Dow Jones industrial average rose about 120 points a day after its record 936-point jump. Investors are hoping that these extraordinary steps by the government will help revive the stagnant credit markets. The Dow’s advance Monday by far outpaced its previous record for a one-day advance, 499.19, scored during the last days of the dot-com boom in 2000.

President Bush said Tuesday the government will use a portion of the $700 billion bailout to inject capital into the nation’s major banks, which have been slammed by souring mortgage investments. The move follows a similar one announced Monday by European governments to invest about $2 trillion in their own troubled banks.

Stocks are seeing increases in the Asian and European markets, as well. Hong Kong’s Hang Seng index rose 3.19 percent, after a more than 10 percent increase on Monday. Japan’s Nikkei index, catching up from the country’s market holiday Monday, jumped 14.15 percent — the largest increase ever. In afternoon trading in Europe, Britain’s FTSE 100 jumped 5.57 percent, Germany’s DAX index rose 5.26 percent, and France’s CAC-40 rose 4.97 percent.

Banks appear to be growing somewhat more willing to lend to one another. The London interbank offered rate (LIBOR) for three-month dollar loans fell to 4.64 percent from 4.75 percent, after a 0.07 percentage point dip on Monday. LIBOR is important because many consumer loans, including about half of all adjustable-rate mortgages, are tied to it.  Even FHA home refinancing has slowed as borrowers wait to see what the Federal Reserve has up his sleeve.

“This begins to penetrate the core of the problem,” said Peter Cardillo, chief market economist at New York-based brokerage house Avalon Partners Inc.  But, he said, “There will be a point in time where the euphoria of the bailout plan begins to wear off and the market begins to face reality. And that reality is likely to be a sour earnings season, and that the economy is in recession.”

All we can do is wait to see if the stock market continues its ascent and if banks begin FHA mortgage lending to consumers again. This won’t happen immediately, but at least there seems to be light at the end of the tunnel. At this point, conventional lenders are still not lending to anyone with a credit score of less than 700. If you’re looking to purchase or refinance your loan, FHA loans still remains the best bet.

FHA has received a lot of press in the news lately mainly because of the two foreclosure rescue programs: FHASecure and HOPE for Homeowners. But, did you know the FHA has several other refinance loan programs available to those looking to buy a home and those looking to refinance? Here are some of those programs:

• 203(b) – this is the standard single-family home loan program. It’s the loan most people have heard of because it’s the most common purchase loan program.

• FHA/VA 203(v), also known as the FHA/VA Tandem Loan – Most people haven’t heard of this one because it’s only available to veterans. Those who have used their VA eligibility or those who want to use their VA certificate later on can use it. The FHA/VA loan doesn’t involve the veteran’s entitlement, and there are no limits on how often the loan can be utilized. Veterans can only finance single-family homes with this loan. They are not allowed to finance duplex or other multi-family properties.

• The FHA Adjustable-Rate Mortgage (FHA ARM) combines the three-percent down payment guidelines of the standard 203(b) program with the features of an ARM. But, unlike the subprime ARMs and exotic hybrid ARMs (interest only and negative amortization loans), the FHA ARM does not allow negative amortization, and maximum interest rate increase caps are limited to 1 percent per year and 5 percent over the life of the loan.

• Section 245’s FHA Graduated Payment Mortgage (GPM) plan allows a borrower to pay lower initial monthly payments during the early years of the loan. Mortgage payments are structured to rise gradually for a set period of time, generally from five to seven years, and then remain fixed for the remainder of the loan. This enables borrowers to grow into higher monthly payments as their income increases.

• The FHA Growing Equity Mortgage (GEM), under Section 245(a), is designed to allow the borrower to grow equity in his or her property at a faster rate than with the traditional 30-year mortgages, while at the same time keeping payments low during the early years of the loan. With the GEM, payments increase between 2 percent and 7-1/2 percent each year (depending upon the particular plan), with the increase being applied directly to the principal balance. The loan is thereby retired in approximately fifteen years, dramatically reducing the overall cost of the mortgage.

• Section 203(h) is available to anyone whose home has been destroyed or severely damaged in a federally declared disaster area. The funds can be used to rebuild the home or purchase a new one; however, the borrower’s application must be filed with the Department of Housing and Urban Development (HUD) within one year of the President’s declaration of the disaster. Under this program, 100 percent loans can be obtained (including closing costs). The borrower can pay prepaid expenses such as property taxes and insurance, or the lender can premium price the loan (charge more interest) and pay the prepaid items for the borrower.

• Section 203(k) insures loans used to rehabilitate existing residential properties that will be used for residential purposes, or to convert non-residential buildings to residential use or change the number of family units in the dwelling. The 203(k) provides the borrower with interim and permanent financing in one loan. The loan amount, which is based on the property’s after-renovation value, cannot exceed the current FHA maximum mortgage in the borrower’s area.

• FHA Title I program – this is similar to the 203(b) program, but it’s for manufactured housing. A borrower can receive financing for the purchase of a manufactured home and land. The program can also be used to buy just the home if land is already owned, or land if the borrower already owns the manufactured home.

Are you looking to buy a home? If you already own a home, are you looking to refinance? FHA is the best loan option available. Unlike conventional lenders stuck in the credit freeze, FHA home loans are available. Credit underwriting for these loans is quite reasonable, too. FHA home refinancing is flexible and funding is much faster than it used to be. Fill out the loan quote form on this page for more information.