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The problem with the short-refi program

October 04, 2011

| Money Rates Columnist

The FHA's short-refi program for underwater borrowers was announced last August and the results are in: In a one-year period there have been just 891 applications and 305 originations under the program.

How did this happen? With countless foreclosure notices created each year, how come the FHA program has gained so little traction?

"We're throwing a life line out to those families who are current on their mortgage and are experiencing financial hardships because property values in their community have declined," said former FHA Commissioner David H. Stevens in the announcement last year. "This is another tool to help overcome the negative equity problem facing many responsible homeowners who are looking to refinance into a safer, more secure mortgage product."

So what kind of a lifeline was thrown out?

Under the short-refi program, an underwater borrower could qualify for a new loan under several conditions:

  • The loan has to be current.
  • The property has to be owner-occupied, with one to four units.
  • The existing loan cannot be an FHA mortgage.
  • The lender of the existing loan has to agree to a 10-percent principal reduction.
  • The refinanced FHA-insured first mortgage must have a loan-to-value ratio of no more than 97.75 percent.

In other words, this loan is designed for a borrower with good credit, who has been making monthly payments but cannot get a lower mortgage rate because the existing debt is greater than the value of the property.

The key question, though, is who will pay for the property's loss of value under the new loan? Under the short-refi plan, it's the lender who is expected to pay by reducing the size of the debt. Lenders, of course, are not keen on such an arrangement--the very reason so few have agreed to the program.

Lessons in loss

Imagine that a home was purchased for $500,000 with five percent down. The original loan amount was $475,000. After five years the value of the property today is $425,000. If the property was refinanced for 97.75 percent of the current fair market value, the new mortgage amount would be $415,437.

If you were a lender, would you accept the new loan in full payment of the original debt, even if the debt is now somewhat smaller as a result of amortization?

From the lender's perspective, the current loan is fine. The borrower is making payments and as long as payments keep coming, the lender has no reason to prefer a refinance of the property to a new rate and certainly no reason to want a lower principal debt.

The real problem with the short-refi program is that it illustrates how difficult it will be to refinance the millions of home loans that could benefit from refinancing and a lower mortgage rate. On a voluntary basis, few lenders will make such a deal.

Of the roughly 300 loans that were refinanced, one can easily imagine why: The properties were located in major foreclosure centers where a foreclosure or bankruptcy would expose the lender to even worse losses. In such circumstances it might make sense for the lender to accept the FHA program and avoid even bigger problems.


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