Academic journal article Real Estate Economics

Credit History and the FHA-Conventional Choice

Academic journal article Real Estate Economics

Credit History and the FHA-Conventional Choice

Article excerpt

Anthony Pennington-Cross [*]

Joseph Nichols [**]

Models explaining whether households choose conventional or FHA mortgage financing typically use differential insurance premiums, loan-to-value (LTV) and payment-to-income underwriting standards, and local economic conditions to explain household behavior. Using a large and geographically diverse sample, we expand the standard choice model by including measures of borrower credit history. We find that the ability of a homebuyer to avoid credit problems is an important part of the FHA-conventional choice. In addition, credit scores of FHA borrowers are worse on average than those of conventional borrowers, but as LTV increases credit scores of conventional borrowers deteriorate.

An important part of the home purchase decision is which type of mortgage insurance, conventional or FHA, to use. if a borrower needs mortgage insurance, FHA insurance costs more but underwriting standards are more lenient making FHA insurance attractive to a substantial proportion of buyers. This paper explores the effects of down-payment, income and credit-history constraints on the FHA--conventional mortgage choice.

Two major data innovations are included. First, credit history is included in the analysis. This allows us to examine the relative importance of avoiding credit problems, down payments and income. Second, a large sample of loans allows us to include MSA-specific fixed effects.

The literature has found that down-payment size and income are important determinants of both tenure choice (Haurin, Hendershott and Wachter 1997; Haurin 1991; Linneman and Wachter 1989) and mortgage choice (Hendershott, LaFayette and Haurin 1997, 1995). However, these studies did not include the effect of the third constraint, the borrower's credit history or behavior. The inclusion of borrower credit behavior could significantly alter the effects of income and down-payment constraints on mortgage choice.

For instance, a lender may allow higher loan-to-value (LTV) or higher payment-to-income (PTI) ratios if the borrower has excellent credit.

There have been some attempts to utilize a measure of credit risk to explain the probability of mortgage default (Avery et al. 1996). However, the literature has not previously studied the effect of credit history on the demand for housing and mortgage choice. The use of credit-history measures is especially important given the growing evidence that households change their labor effort and savings patterns shortly before becoming homeowners (e.g., Kolhase 1986, Fortin 1995, Goodman and Nichols 1997). In contrast, it is difficult to adjust credit history; and some measures, such as the number of credit lines that have ever been derogatory, can take years to cure. Credit-history measures may provide a more accurate long-run description of how the household manages resources than down payments and current income streams.

In addition to being unable to include credit history, prior studies have been limited by two other problems. First, surveys with fairly small samples sizes [America Housing Survey (AHS), Survey of Consumer Finance, National Longitudinal Survey, Survey of Consumer Credit] are typically used to study households' choice. While the overall number of households sampled is typically large, the number of housing purchases is small. For instance, Hendershott, Lafayette and Haurin (1997) use the AHS and have 581 observations from the entire nation to estimate the FHA--conventional choice. Second, these surveys depend on the households to report their financial situation. Potential bias is introduced whenever individuals are asked to report on their own finances, in part due to an individual's unwillingness to disclose financial information and the inability of an individual to report financial information objectively. In fact, people may not even be aware of whether any derogatory information is on their credit repor t. …

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