Mortgage Financing: Seller-Funded Down-Payment Assistance Changes the Structure of the Purchase Transaction and Negatively Affects Loan Performance
Published: 2007-06-22T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Federal Housing Administration (FHA) differs from other key mortgage industry participants in that it allows borrowers to obtain down-payment assistance from nonprofit organizations (nonprofits) that operate programs supported partly by property sellers. Research has raised concerns about how this type of assistance affects home purchase transactions. To assist Congress in considering issues related to down-payment assistance, this testimony provides information from GAO's November 2005 report, Mortgage Financing: Additional Action Needed to Manage Risks of FHA-Insured Loans with Down Payment Assistance (GAO-06-24). Specifically, this testimony discusses (1) trends in the use of down-payment assistance with FHA-insured loans, (2) the impact that the presence of such assistance has on purchase transactions and house prices, and (3) the influence of such assistance on loan performance.
section_title: What GAO Found
paragraphs: The proportion of FHA-insured purchase loans that were financed in part by down-payment assistance increased from 35 percent to nearly 50 percent from 2000 through 2004. Assistance from nonprofit organizations that received at least part of their funding from property sellers accounted for much of this increase, growing from about 6 percent of FHA-insured purchase loans in 2000 to approximately 30 percent in 2004. More recent data indicate that in 2005 and 2006, the percentages of FHA-insured loans with down-payment assistance from all sources and from seller-funded nonprofits were roughly equivalent to 2004 levels. Assistance from seller-funded nonprofits alters the structure of the purchase transaction in important ways. First, because many seller-funded nonprofits require property sellers to make a payment to their organization, assistance from these nonprofits creates an indirect funding stream from property sellers to homebuyers. Second, GAO analysis indicated that FHA-insured homes bought with seller-funded nonprofit assistance were appraised at and sold for about 2 to 3 percent more than comparable homes bought without such assistance. Regardless of the source of assistance and holding other variables constant, GAO analysis indicated that FHA-insured loans with down-payment assistance have higher delinquency and insurance claim rates than do similar loans without such assistance. Furthermore, loans with assistance from seller-funded nonprofits do not perform as well as loans with assistance from other sources. This difference may be explained, in part, by the higher sales prices of comparable homes bought with seller-funded assistance and the homebuyers having less equity in the transaction.

section_title: Letter
paragraphs: I am pleased to be here today to discuss issues concerning down-payment  assistance for homebuyers. Making a down payment on a mortgage can  benefit both the homebuyer and the mortgage provider. For example, a  down payment creates “instant equity” for the new homeowner, and we  and others have shown that mortgage loans with greater owner investment  generally perform better. However, many families have difficulty saving  sufficient funds for a down payment and loan closing costs. One way to  make homeownership affordable to more families is to allow homebuyers  to obtain these funds from third parties such as relatives, employers,  government agencies, and nonprofit organizations (nonprofits).
Like many conventional lenders, the Federal Housing Administration  (FHA) of the Department of Housing and Urban Development (HUD)  allows down-payment assistance from third-party sources. One of the  primary goals of FHA, which insures single-family mortgages made by  private lenders, is to expand homeownership opportunities for first-time  homebuyers and other borrowers who would not otherwise qualify for  conventional mortgages on affordable terms. FHA borrowers often have  limited resources to meet the 3 percent borrower investment FHA requires  and many obtain down-payment assistance. Unlike other key mortgage  industry participants, FHA allows borrowers to obtain this assistance from  nonprofits that operate programs supported partly by financial  contributions and service fees from participating property sellers.
My testimony today is based on a report we issued in November 2005 on  down-payment assistance used with FHA-insured mortgages. My  discussion will focus on (1) trends in the use of down-payment assistance  with FHA-insured loans, (2) the impact that the presence of such  assistance has on purchase transactions and house prices, and (3) the  influence of such assistance on loan performance.
In preparing our November 2005 report, we analyzed loan-level data from  HUD on single-family home purchase mortgages. These data included two  samples of FHA-insured loans from fiscal years 2000, 2001, and 2002—a  national sample and a sample from three metropolitan statistical areas  (MSA) with high rates of down-payment assistance—and performance  data on those loans as of June 30, 2005. We reviewed FHA reports and  guidance for loans with down-payment assistance and examined practices  used by other mortgage industry participants for loan products that permit  similar assistance. We also examined the sales prices of homes by the use  and source of down-payment assistance using property value estimates  derived from an Automated Valuation Model (AVM). Finally, we  interviewed real estate agents, lenders, appraisers, and other key players  involved in transactions with down-payment assistance.
In summary, we found that:    The proportion of FHA-insured purchase loans that were financed in part  by down-payment assistance from various sources increased from 35  percent to nearly 50 percent from 2000 through 2004, while the overall  number of loans that FHA insured fell sharply. Assistance from nonprofit  organizations funded by property sellers accounted for a growing  percentage of that assistance. More specifically, about 6 percent of FHA- insured loans in 2000 received down-payment assistance from seller- funded nonprofits, but by 2004 nonprofit assistance had grown to about 30  percent. More recent data indicate that in 2005 and 2006, the percentages  of FHA-insured loans with down-payment assistance from all sources and  from seller-funded nonprofits were roughly equivalent to 2004 levels.
Down-payment assistance provided by a seller-funded nonprofit can alter  the structure of the purchase transaction in important ways. First, when  homebuyers receive such assistance, many of the nonprofits require  property sellers to make a payment to the nonprofit that equals the  amount of assistance the homebuyer receives, plus a service fee, after the  closing. This requirement creates an indirect funding stream from property  sellers to homebuyers that does not exist in other transactions, even those  involving some other type of down-payment assistance. Second, according  to mortgage industry participants and a HUD contractor’s study, property  sellers that have provided down-payment assistance through nonprofits  then often raised the sales prices of the homes involved in order to recover  the required payments to the organizations. Similarly, our analysis found  that FHA-insured homes bought with seller-funded nonprofit assistance  were appraised at and sold for about 2 to 3 percent more than comparable  homes bought without such assistance.
Loans with down-payment assistance do not perform as well as loans  without down-payment assistance. This may be partially explained by the  homebuyer having less equity in the transaction. Holding other variables  constant, our analysis indicated that FHA-insured loans with down- payment assistance had higher delinquency and insurance claim rates than  similar loans without such assistance. For example, we found that the  probability that loans with down-payment assistance from a seller-funded  nonprofit would result in insurance claims was 76 percent higher in the  national sample and 166 percent higher in the MSA sample than it was for  comparable loans without assistance. These differences in performance  may also be explained, in part, by the higher sales price of comparable  homes bought with seller-funded down-payment assistance. Due partly to  the adverse performance of loans with seller-funded down-payment  assistance, FHA has estimated that in the absence of program changes its  single-family mortgage insurance program would require a subsidy—that  is, appropriations—in 2008.
Our 2005 report made recommendations designed to better manage the  risks of loans with down-payment assistance generally and from seller- funded nonprofits specifically. Consistent with our recommendations,  HUD, among other things, recently issued a proposed rule that would  prohibit the use of seller-funded down-payment assistance in conjunction  with FHA-insured loans.
subsections: section_title: Background
paragraphs: Congress established FHA in 1934 under the National Housing Act (P.L. 73- 479) to broaden homeownership, protect and sustain lending institutions,  and stimulate employment in the building industry. FHA’s single-family  programs insure private lenders against losses from borrower defaults on  mortgages that meet FHA’s criteria for properties with one to four housing  units. FHA historically has played a particularly large role among minority,  lower-income, and first-time homebuyers. In 2006, 79 percent of FHA- insured home purchase loans went to first-time homebuyers, 31 percent of  whom were minorities.
In recent years, FHA’s volume of business has fallen sharply. More  specifically, the number of single-family loans that FHA insured fell from  about 1.3 million in 2002 to 426,000 in 2006. To help FHA adapt to recent  trends in the mortgage market, in 2006 HUD submitted a legislative  proposal to Congress that included changes that would adjust loan limits  for the single-family mortgage insurance program, eliminate the  requirement for a minimum down payment, and provide greater flexibility  to FHA to set insurance premiums based on risk factors. According to  HUD, a zero-down-payment mortgage product would provide FHA with a  better way to serve families in need of down-payment assistance.
As previously noted, some nonprofits that provide down-payment  assistance receive contributions from property sellers. When a homebuyer  receives down-payment assistance from one of these organizations, the  organization requires the property seller to make a financial payment to  their organization. These nonprofits are commonly called “seller-funded”  down-payment assistance providers. A 1998 memorandum from HUD’s  Office of the General Counsel found that funds from a seller-funded  nonprofit were not in conflict with FHA’s guidelines prohibiting down- payment assistance from sellers. FHA does not approve down-payment  assistance programs administered by nonprofits. Instead, lenders are  responsible for assuring that down-payment assistance from a nonprofit  meets FHA requirements.
section_title: Purchase Loans with Seller-Funded Down- Payment Assistance Have Become a Substantial Part of FHA’s Portfolio and Are More Prevalent in Areas with Lower House Price Appreciation
paragraphs: Loans with down-payment assistance have come to constitute a  substantial portion of FHA’s portfolio in recent years, particularly as the  number of loans without such assistance has fallen sharply. For example,  from 2000 to 2004, the total proportion of FHA-insured single-family  purchase loans that had a loan-to-value (LTV) ratio greater than 95 percent  and that also involved down-payment assistance from any source grew  from 35 to nearly 50 percent. Assistance from nonprofit organizations,  about 93 percent of which were funded by sellers, accounted for an  increasing proportion of this assistance. Approximately 6 percent of FHA- insured loans received down-payment assistance from nonprofit  organizations in 2000, but, by 2004 this figure had grown to about 30  percent. FHA data for 2005 and 2006 indicate that the percentages of loans  with down-payment assistance from any source and from seller-funded  nonprofits remained at roughly 2004 levels.
Growth in the number of seller-funded nonprofit providers and the greater  acceptance of this type of assistance have contributed to the increase in  the use of down-payment assistance. According to industry professionals,  relatives have traditionally provided such assistance, but in the past  decade or so other sources have emerged, including not only seller-funded  nonprofit organizations but also government agencies and employers. The  mortgage industry has responded by developing practices to administer  this type of assistance, for instance, FHA policies require gift letters and  documentation of the transfer of funds. Lenders also reported that seller- funded down-payment assistance providers have developed practices  accepted by FHA and lenders. For example, seller-funded programs have  standardized gift letter and contract addendum forms for documenting  both the transfer of down-payment assistance funds to the homebuyer and  the financial contribution from the property seller to the nonprofit  organization. As a result, for FHA-insured loans, lenders are increasingly  aware of and willing to accept down-payment assistance, including from  seller-funded nonprofits.
We found that states that have higher-than-average percentages of FHA- insured loans with nonprofit down-payment assistance, primarily from  seller-funded programs, tended to be states with lower-than-average house  price appreciation rates. From May 2004 to April 2005, 35 percent of all  FHA-insured purchase loans nationwide involved down-payment  assistance from a nonprofit organization, and 15 states had percentages  that were higher than this nationwide average. Fourteen of these 15 states  also had house price appreciation rates that were below the median rate  for all states. In addition, the eight states with the lowest house price  appreciation rates in the nation all had higher-than-average percentages of  nonprofit down-payment assistance. Generally, states with high  proportions of FHA-insured loans with nonprofit down-payment  assistance were concentrated in the Southwest, Southeast, and Midwest.
section_title: Seller-Funded Assistance Affects Home Purchase Transactions and Can Raise House Prices
paragraphs: The presence of down-payment assistance from seller-funded nonprofits  can alter the structure of purchase transactions. When buyers receive  assistance from sources other than seller-funded nonprofits, the home  purchase takes place like any other purchase transaction—buyers use the  funds to pay part of the house price, the closing costs, or both, reducing  the mortgage by the amount they pay and creating “instant equity.”  However, seller-funded down-payment assistance programs typically  require property sellers to make a financial contribution and pay a service  fee after the closing, creating an indirect funding stream from property  sellers to homebuyers that does not exist in a typical transaction   (see fig. 1).
Our analysis indicated, and mortgage industry participants we spoke with  reported, that property sellers often raised the sales price of their  properties in order to recover the contribution to the seller-funded  nonprofit that provided the down-payment assistance. Marketing materials  from seller-funded nonprofits often emphasize that property sellers using  these down-payment assistance programs earn a higher net profit than  property sellers who do not. These materials show sellers receiving a  higher sales price that more than compensates for the fee typically paid to  the down-payment assistance provider. Several mortgage industry  participants we interviewed noted that when homebuyers obtained down- payment assistance from seller-funded nonprofits, property sellers  increased their sales prices to recover their payments to the nonprofits  providing the assistance. An earlier study by a HUD contractor  corroborates the existence of this practice. Some mortgage industry  participants we met with told us that they viewed down-payment  assistance from seller-funded nonprofits as a seller inducement. However,  FHA has not viewed such assistance as a seller inducement and therefore  does not subject this assistance to the limits that it otherwise places on  contributions from sellers.
Some mortgage industry participants told us that homes purchased with  down-payment assistance from seller-funded nonprofits might be  appraised for higher values than they would be without this assistance.  Appraisers we spoke with said that lenders, realtors, and sellers  sometimes pressured them to “bring in the value” in order to complete the  sale. The HUD contractor study corroborates the existence of these  pressures. Our analysis of a national sample of FHA-insured loans  endorsed in 2000, 2001, and 2002 suggested that homes with seller-funded  assistance were appraised and sold for about 3 percent more than  comparable homes without such assistance. Additionally, our analysis of  more recent loans—a sample of FHA-insured loans settled in March  2005—indicated that homes sold with nonprofit assistance were appraised  and sold for about 2 percentage points more than comparable homes  without nonprofit assistance.
section_title: FHA-Insured Loans with Down Payment Assistance, Particularly from Seller-Funded Nonprofits, Do Not Perform as Well as Similar Loans without Assistance
paragraphs: We found that FHA-insured loans with down-payment assistance do not  perform as well as loans without it. As part of our evaluation, we analyzed  loan performance by source of down-payment assistance, controlling for  the maximum age of the loan, as of June 30, 2005. We used two samples of  FHA-insured purchase loans from 2000, 2001, and 2002—a national sample  and a sample from three MSAs with high rates of down-payment  assistance. We grouped the loans into the following three categories: loans  with assistance from seller-funded nonprofit organizations, loans with  assistance from nonseller-funded sources, and loans without assistance.  As shown in figure 2, in both samples and in each year, loans with down- payment assistance from seller-funded nonprofit organizations had the  highest rates of delinquency and insurance claims, and loans without  assistance the lowest. Specifically, between 22 and 28 percent of loans  with seller-funded assistance had experienced a 90-day delinquency,  compared with 11 to 16 percent of loans with assistance from other  sources and 8 to 12 percent of loans without assistance. The claim rates  for loans with seller-funded assistance ranged from 6 to 18 percent, for  loans with other sources of assistance from 5 to 10 percent, and for loans  without assistance from 3 to 6 percent.
In addition, we analyzed loan performance by source of down-payment  assistance holding other variables constant. Here we found that FHA- insured loans with down-payment assistance had higher delinquency and  claim rates than similar loans without such assistance (see fig. 3). The  results from the national sample indicated that assistance from a seller- funded nonprofit raised the probability that the loan had gone to claim by  76 percent relative to similar loans with no assistance. Differences in the  MSA sample were even larger; the probability that loans with seller-funded  nonprofit assistance would go to claim was 166 percent higher than it was  for comparable loans without assistance. Similarly, results from the  national sample showed that down-payment assistance from a seller- funded nonprofit raised the probability of delinquency by 93 percent  compared with the probability of delinquency in comparable loans without  assistance. For the MSA sample, this figure was 110 percent.
The weaker performance of loans with seller-funded down-payment  assistance may be explained, in part, by the higher sales prices of homes  bought with this assistance and the homebuyer having less equity in the  transaction. The higher sales price that often results from a transaction  involving seller-funded down-payment assistance can have the perverse  effect of denying buyers any equity in their properties and creating higher  effective LTV ratios. FHA has requirements which have the effect of  ensuring that FHA homebuyers obtain a certain amount of “instant equity”  at closing, but seller-funded down-payment assistance effectively  undercuts these requirements. That is, when the sales price represents the  fair market value of the house, and the homebuyer contributes 3 percent  of the sales price at the closing, the LTV ratio is less than 100 percent. But  when a seller raises the sales price of a property to accommodate a  contribution to a nonprofit that provides down-payment assistance to the  buyer, the buyer’s mortgage may represent 100 percent or more of the  property’s true market value. Our prior analysis has found that, controlling  for other factors, high LTV ratios lead to increased claims.
The adverse performance of loans with seller-funded down-payment  assistance has had negative consequences for FHA. FHA has estimated  that its single-family mortgage insurance program would require a  subsidy—that is, appropriations—in 2008 in the absence of program  changes. According to FHA, the growing share of FHA-insured purchase  loans with seller-funded assistance has contributed to FHA’s worsening  financial performance.
Our 2005 report made recommendations designed to better manage the  risks of loans with down-payment assistance generally and from seller- funded nonprofits specifically. We recommended that FHA consider risk  mitigation techniques such as including down-payment assistance as a  factor when underwriting loans. We also recommended that FHA take  additional steps to mitigate the risk associated with loans with seller- funded down-payment assistance, such as treating such assistance as a  seller inducement and therefore subject to the prohibition against using  seller contributions to meet the 3 percent borrower contribution  requirement.
Consistent with our recommendations, FHA is testing additional predictive  variables, including source of the down payment, for inclusion in its  mortgage scorecard (an automated tool that evaluates the default risk of  borrowers). Additionally, in May 2007 HUD issued a proposed rule that  would prohibit the use of seller-funded down-payment assistance in  conjunction with FHA-insured loans. FHA also has been anticipating a  reduction in the number of loans with down-payment assistance from  seller-funded nonprofit organizations as a result of actions taken by the  Internal Revenue Service (IRS). Citing concerns about seller-funded  nonprofits raised by our report and the 2005 HUD contractor study, IRS  issued a ruling in May 2006 stating that these organizations do not qualify  as tax-exempt charities, thereby making loans with such assistance  ineligible for FHA insurance. In a press announcement of the ruling, IRS  stated that funneling down-payment assistance from sellers to buyers  through “self-serving, circular-financing arrangements” is inconsistent with  operation as a charitable organization. According to FHA, as of June 2007,  IRS had rescinded the charitable status of three of the 185 organizations  that IRS is examining.
Madam Chairwoman, this concludes my prepared statement. I would be  happy to answer any questions at this time.
section_title: Contacts and Acknowledgments
paragraphs: For further information on this testimony, please contact William B. Shear  at (202) 512-8678 or shearw@gao.gov. Individuals making key  contributions to this testimony included Steve Westley (Assistant  Director), Emily Chalmers, Chris Krzeminski, and Andy Pauline.
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