The Federal Housing Finance Agency’s announcement that Fannie Mae will consider rental payment history in mortgage approval decisions represents a significant innovation and a major step forward in expanding homeownership opportunities. In addition to increasing the pool of qualified borrowers, it enhances the safety of mortgages backed by Fannie Mae by fully considering the most relevant predictor of mortgage risk: housing payment history.
You might reasonably ask, isn’t rental payment history already taken into account? Unfortunately, in most cases, the answer is no. Some landlords report missed payments, but there isn’t a mechanism for regular reporting of on-time payments. Some have asked why missed payments are not counted against applicants as well. It’s a reasonable question. The reason is that we can’t tell when a landlord deposited a rental payment from a renter’s bank statement. If payments appear on a bank statement with regularity, it’s a good indication of a stable payment history. The absence of a payment on the statement does not necessarily indicate it wasn’t paid. It could have been paid in cash, or from another account. So, we can’t count it against them, but we also can’t count it for them. This limits the full positive impact, but not the negative impact.
For those not familiar with the home mortgage underwriting process, a variety of factors are considered in assessing the creditworthiness of a borrower. One factor is the history of paying one’s bills on time. The information collected by the three largest credit reporting agencies is combined to ensure all late or delinquent payments are evaluated. These are entered into a model to yield a credit risk score, the most common being the FICO score. Alternate ways of analyzing this credit history are also used, including the Vantage score. Past performance is an important indicator of future performance. However, many first-generation homebuyers, who are disproportionately people of color, are disadvantaged by having nontraditional credit or “thin files” with fewer credit lines to analyze. Addressing racial disparities as a result of these and other factors is an important part of responsibly expanding credit access.
Other factors contributing to analyzing credit risk include debt to income (DTI) ratios, loan to value (LTV), and financial reserves.
- DTI is the borrower’s monthly debt divided by their monthly income. Total monthly debt— the monthly cost of the mortgage, including principal, interest taxes, and insurance (PITI), plus other debts like car and credit card payments, is called the “back-end ratio.” The PITI divided by monthly income is called the “front-end ratio.” The front-end ratio should be between 28% and no more than 31%. The back-end ratio should be less than 43-45%.
- The LTV is the loan amount divided by the price of the house, which needs to be confirmed by an appraisal before closing. A 20% down payment has an LTV of 80. A 3% downpayment has an LTV of 97.
- Submitting bank statements, which is now usually done electronically, confirms income and reserves, which are important to ensure the borrower can afford unexpected expenses like a leaky roof or broken water heater. Most lenders like to see reserves of at least two monthly mortgage payments.
These rules used to be very firm, but in the early 1990s, mortgage underwriting began embracing the concept of compensating factors. As underwriting became more automated, it was easier to balance these factors into an overall mortgage risk assessment, or mortgage score. A higher credit score might offset a higher back-end DTI ratio. Though one’s debts were higher than ideal, a strong history of on-time payments could be an offset. A small downpayment loan is riskier than a larger one, but a 20% downpayment with a poor credit history is riskier than a small downpayment with an excellent credit history.
During the run-up to the Great Recession, many lenders increasingly ignored these rules and layered risk factors on top of each other rather than compensated for them. We all know how that went. But the pendulum has swung far in the opposite direction. Now, an extremely tight mortgage credit box means that millions of potential homebuyers are left out who would have qualified before the period of irresponsible lending prevalent in the early 2000s.
Including rent history in the overall risk profile will make a big difference for many borrowers who are close to qualifying for a mortgage but not quite there. This is because the best way to predict whether you’ll make your housing payments in the future is whether you’ve made them in the past. According to a report by the Urban Institute, “borrowers who had no missed payments in the 24-month period performed extraordinarily well over the next three years, even if they had both low FICO and high LTV loans. For example, those who had FICO scores below 700 and an 80–95 LTV had a default rate of 1.14%. This is dramatically lower than similar borrowers with one missed payment (10.27 %), two missed payments (34.83%), and three or more missed payments (60%).”
The new procedure will utilize information available to lenders without adding any burden to their loan officers, homebuyers, or landlords. By analyzing bank statements submitted electronically, Fannie Mae Desktop Underwriter automated underwriting system will be able to confirm that past rent payments were made on time. When Fannie Mae tested the system on past applicants that were not approved, 17% would have qualified had their rent payment history been considered. This will have a material impact on mortgage applicants who are qualified but have been left out of homeownership.
This new policy in mortgage underwriting is an important innovation. We can expect others to adopt it quickly as more data is analyzed and automated underwriting systems are updated. Homeownership is a foundational element of the American Dream and the most impactful way low- and moderate-income families build wealth. It’s good for all of us that more families will have access to homeownership as a result of this decision.