Table 1 illustrates some of the  major similarities and differences in the eligibility criteria of FHA and other  mortgage institutions. Many institutions permit down payment assistance. FHA  borrowers may also finance their insurance premium. This investment requirement can be used to pay either the  down payment and in some cases the closing costs. On the other hand, another private insurer recommends, but does not  require, prepurchase counseling for first-time homebuyers in its low and no  down payment products. Research Shows LTV Ratio and Credit Score Are Important When Estimating Risk of Individual Mortgages

Economic research we reviewed indicated that LTV ratios and credit scores  are among the most important factors when estimating the risk level  associated with individual mortgages. FHA-Insured Mortgages with Higher LTV Ratios and Lower Credit Scores Are Riskier Than Other FHA-Insured Mortgages

When considering LTV alone, FHA-insured mortgages with higher LTV  ratios (smaller down payments) generally perform worse than FHA-insured  mortgages with lower LTV ratios. Several Practices Mortgage Institutions Use in Designing and Implementing Low and No Down Payment Products Could Be Instructive for FHA

Mortgage institutions we spoke with used a number of similar practices in  designing and implementing new products, including low and no down  payment products. FHA does  sometimes use practices for limiting a new product but usually does not  pilot products on its own initiative, and FHA officials question the  circumstances in which they can limit the availability of a program and told  us they do not have the resources to manage programs with limited  availability. Mortgage Institutions Require Additional Credit Enhancements or Stricter Underwriting for New Low and No Down Payment Products

Some mortgage institutions require additional credit  enhancements—mechanisms for transferring risk from one party to  another—on low and no down payment products and set stricter  underwriting requirements for these products. However, when FHA introduces new products or makes significant  changes to existing products with risks that are not well understood, such  actions could introduce significant risks when implemented broadly. Recommendations for Executive Action

If Congress provides the authority for FHA to implement a no down  payment mortgage product or other products about which the risks are not  well understood, we recommend that the Secretary of HUD direct the  Assistant Secretary for HUD-Federal Housing Commissioner to consider  the following three actions:   incorporating stricter underwriting criteria such as appropriate credit  score thresholds or borrower reserve requirements,  piloting the initial product or limiting its initial availability and asking  Congress for the authority if HUD officials determine they currently do  not have this authority, and  utilizing other techniques for mitigating risks including use of credit  enhancements and prepurchase counseling. To report on the volume of mortgage  products, we reviewed relevant reports including reports from the U.S.  Department of Housing and Urban Development (HUD). To do this, we  defined default as a credit event that includes foreclosed mortgages, as  well as mortgages that did not experience foreclosure, but that would  typically lead to a credit loss, such as a “short sale” or a “deed-in-lieu of  foreclosure” termination of the mortgage;  selected six LTV ratio categories;  selected six credit score categories;  combined Fannie Mae and Freddie Mac mortgage volume and   combined mortgage volume and performance data for the sample (of  mortgages insured by FHA in 1992, 1994, and 1996; and conventional  mortgages originated in 1997, 1998, and 1999 and purchased by Fannie  Mae or Freddie Mac);   calculated the average 4-year default rate for FHA (weighted average)  and for all conventional loans separately by dividing the total dollar  amount of mortgages experiencing a credit event by the total dollar  amount of mortgages originated (for FHA) or purchased (for  conventional);   calculated the average 4-year default rates for sampled FHA loans and  for conventional loans that fell within each LTV ratio and credit score  category; and  calculated the relative 4-year default rates for each LTV ratio and credit  score categories for FHA loans and for conventional loans by dividing  the average 4-year default rate for each specific LTV and credit score  category by the average 4-year default rate for sampled FHA loans and  all conventional loans, respectively.
Why GAO Did This Study

The U.S. Department of Housing and Urban Development (HUD), through its Federal Housing Administration (FHA), insures billions of dollars in home mortgage loans made by private lenders. FHA insures low down payment loans and a number of parties have made proposals to either eliminate or otherwise change FHA's borrower contribution requirements. GAO was asked to (1) identify the key characteristics of existing low and no down payment products, (2) review relevant literature on the importance of loan-to-value (LTV) ratios and credit scores to loan performance, (3) report on the performance of low and no down payment mortgages supported by FHA and others, and (4) identify lessons for FHA from others in terms of designing and implementing low and no down payment products.

What GAO Found

FHA and many other mortgage institutions provide many low and no down payment products with requirements that vary in terms of eligibility, borrower investment, underwriting, and risk mitigation. While these products are similar, there are some important differences, including that FHA has lower loan limits, allows closing costs and the up-front insurance premium to be financed in the mortgage, and permits the down payment funds to come from nonprofits that receive funds from sellers. FHA also differs in that it does not require prepurchase counseling. A substantial amount of research GAO reviewed indicates that LTV ratio and credit score are among the most important factors when estimating the risk level associated with individual mortgages. GAO's analysis of the performance of low and no down payment mortgages supported by FHA and others corroborates key findings in the literature. Generally, mortgages with higher LTV ratios (smaller down payments) and lower credit scores are riskier than mortgages with lower LTV ratios and higher credit scores. Some practices of other mortgage institutions offer a framework that could help FHA manage the risks associated with introducing new products or making significant changes to existing products. Mortgage institutions may impose limits on the volume of the new products they will permit and on who can sell and service these products. FHA officials question the circumstances in which they can limit volumes for their products and believe they do not have sufficient resources to manage a product with limited volumes. Mortgage institutions sometimes require additional credit enhancements, such as higher insurance coverage; and sometimes require stricter underwriting, such as credit score thresholds, when introducing a new low or no down payment product. FHA is authorized to require an additional credit enhancement by sharing risk through co-insurance but does not currently use this authority. FHA has used stricter underwriting criteria but this has not included credit score thresholds.