Are Lower Loan Limits Coming?

Lower loan limits may soon be with us. During the next few weeks, government regulators will decide whether or not to lower mortgage loan limits, one of the key measures used to define a "conventional" loan.

Borrowers in high-cost areas need to care about loan limits. The higher the loan limit, the easier it is to finance more expensive homes. Above the loan limit, borrowers need "jumbo" financing, loans which may require larger down payments, tighter underwriting guidelines and / or higher rates. (Weirdly, mortgage rates for jumbo loans were actually below the interest levels for convention mortgages in early September.)

"Federal officials," said the Wall Street Journal, "are preparing to reduce the maximum size of home-mortgage loans eligible for backing by Fannie Mae and Freddie Mac, a move that is likely to face resistance from some lawmakers in Congress and the real estate industry."

What About Housing Markets?

Well sure, lower loan limits would hamper home sales along both coasts as well as high-cost neighborhoods throughout the country. For instance, the median price of a California home sold in August was $441,330 -- a high figure but not nearly as high as specific areas such as Marin ($987,740), San Francisco ($871,480), or San Mateo ($980,000).

By September 17th, opposition to lower loan limits surfaced. The National Association of Realtors wrote a strong letter to Ed DeMarco, acting director of the Federal Housing Finance Agency, the federal agency that has run Fannie Mae and Fredde Mac since they were nationalized in 2008, saying his agency could not lower loan limits because it had no authority to do so. Raise them yes, reduce them no.

Recent Loan Limits

Loan limits have a long and strange history. The usual arrangement was that Fannie Mae and Freddie Mac would set an identical loan limit at the end of each year based on how much home values had increased during the prior 12 months. Since home values generally rose, so did loan limits. All this came to a crashing halt in 2007. Loan limits should have been lowered based on marketplace performance, but the government simply changed the rules, saying at one point that "not decreasing the limit will eliminate potential operational and implementation issues."

Why there should be "operational and implementation issues" when loan limits are lowered but not when they're raised was never explained. But no matter: in 2008 Congress passed the Housing and Economic Recovery Act (HERA) which said loan limits could either remain stable or rise, but they could never fall regardless of market trends.

To make matters more complex, the old rule was that FHA loans could never exceed 87 percent of the conventional loan limit. This meant FHA loans were always smaller than conventional mortgages.

Today the system is completely backwards. Recent home price trends don't count unless they're rising. The maximum conventional loan limit is now $417,000 for most areas but as much as $625,500 in high-cost communities. The FHA loan limit has a "ceiling" of $729,750 in high-cost areas. The numbers can be higher still outside the continental United States and for residential properties with two, three or four units.

What Lower Loan Limits Will Mean

What happens if loan limits decline? Here are three likely results:

First, borrowers in high-cost areas will have fewer loan options.

Second, a larger number of mortgages will have to be handled by private-sector lenders, lenders willing to make loans without government guarantees. It will also mean less marketplace clout for Fannie Mae and Freddie Mac because they will not be able to compete for high-priced loans.

Third, the story with the FHA is different. The FHA now charges a higher annual insurance fee for loans above $625,500 and requires at least 5 percent down instead of 3.5 percent, but such big loans represent substantially less than 1 percent of all FHA volume. The FHA is generally seen as a financing vehicle for first-time buyers and those in the middle-income brackets, so an end to larger loans would have little practical impact on the program. However, a lower FHA loan limit would -- again -- make financing and refinancing in high-cost areas more difficult.

Until recently loan limits were usually changed with little fuss or hubbub, but this time around the situation may be different if the limits are lowered. It would not be surprising to see such a reduction challenged in court with the argument that the government itself says that loan limits cannot be lowered. The government would then counter with a claim only it can offer: We have the right to change the rules....

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