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

Letter

Background

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.

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

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.

Seller-Funded Assistance Affects Home Purchase Transactions and Can Raise House Prices

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.

FHA-Insured Loans with Down Payment Assistance, Particularly from Seller-Funded Nonprofits, Do Not Perform as Well as Similar Loans without Assistance

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.

Contacts and Acknowledgments

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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