Homebuyers and federal housing policymakers are grappling with the housing market’s limited supply, high prices, and rising interest rates. These trends threaten to make purchasing a home even less of a reality for buyers with low and moderate incomes.

Could a rarely used feature in government-issued loans be a solution?

Federal Housing Administration (FHA) assumable loans—in which the buyer takes over the seller’s interest rate and other applicable mortgage terms—have not been used much in the past 40 years. As interest rates rise, these loans could help break down some barriers to homeownership. But for the assumability feature to realize its full potential, several housing finance reforms would be needed.

What are assumable loans?

Federally backed assumable mortgages are secured by the FHA, the US Department of Veterans Affairs (VA), or the Rural Housing Service (RHS), so if a borrower forecloses, the government pays to ensure the lender doesn’t suffer losses. To understand the value of assumable mortgages, you must understand the components of the home sale transaction. 

When a person buys a home from a homeowner, the homeowner is relieved of any liability to make additional payments on their mortgage, and the homeowner is cashed out of any equity they have in the property. Traditionally, these tasks are completed using the proceeds from the homebuyer’s mortgage and down payment paying off the homeowner’s mortgage and cashing out their equity.

If the current homeowner has a mortgage that is insured by the FHA, the VA, or the RHS, the buyer may assume the seller’s liability to make future mortgage payments. But because the sales price likely exceeds the mortgage’s unpaid balance, the buyer must use a combination of cash and a piggyback mortgage (i.e., a second mortgage layered on top of a first mortgage to generate the funds needed to close the transaction). 

For example, if a buyer wants to purchase a home for $400,000 and there is a $250,000 FHA mortgage on the property, the buyer would assume the $250,000 mortgage. The maximum combined loan-to-value (CLTV) ratio the buyer can expect to obtain with a piggyback second mortgage (a home equity line of credit or a closed-end second) is 80 percent, or $70,000. This means the buyer would be required to make an $80,000 down payment. 

Why are assumable loans suddenly an interesting financing option?

Why would a buyer want to assume the mortgage payment liability from the home seller if they can obtain a new loan at a lower interest rate? Over the past 40 years, the assumability feature has been used rarely because mortgage interest rates have been falling, but that dynamic has turned around over the past six months. 

Home sellers who refinanced or bought their homes during the pandemic are making mortgage payments on a loan with a roughly 3 percent interest rate. But in today’s market, a homebuyer can expect to obtain a mortgage with an interest rate over 6 percent. This boxes out many prospective buyers with low and moderate incomes. But the interest rate differential makes the assumability feature of the seller’s mortgage valuable.

By supporting this financing option, the FHA, the VA, and the RHS are creating an opportunity for buyers with low and moderate incomes compete with cash buyers. 

Assumable loans can be used only by assumed buyers who will be owner-occupants, so creating an environment in which loans can be assumed efficiently gives owner-occupants a financing advantage. Assumable loans enable the value of the mortgage savings to be partially capitalized into the home’s sales price, allowing the owner-occupant to outbid an investor that cannot benefit from assumability. In turn, the loans allow home sellers to receive top dollar for the sale of their home. By maximizing the proceeds from the home sale, the seller—who often has a low or moderate income—will be able to buy their next home in a nicer neighborhood, purchase a larger home, or buy a home in a better school system.

What would it take for assumable loans to realize their potential?

Two steps could make assumable loans more effective:

1. Raising the cap on fees servicers can charge. Servicers can charge up to $900 to process, underwrite, and close a transaction that includes a loan assumption. But that amount cannot compensate servicers for their costs, let alone make a reasonable profit. A Mortgage Bankers Association analysis of Peer Group Roundtable data showed that the direct and indirect costs to process, underwrite, and close a government loan is $2,500.
   
   I suggest a fee of 1.3 percent of the balance of a loan being assumed would be fair to both the borrower and the servicer. Basing the fee on the balance of the loan being assumed will make it proportionate to the value the homebuyer will receive through the assumption.
2. Addressing the inaccessibility of second mortgages. Curinos Home Equity Consortium indicated that to receive an affordable interest rate on a piggyback loan, you need a minimum credit score of 660, a maximum CLTV of 80 percent, and a maximum debt-to-income ratio of 45 percent. Higher CLTV are available on a limited basis at a substantially higher interest rate. These standards are more stringent than the credit requirements of an FHA-insured first mortgage, which means the only borrowers who would be able to assume an FHA loan are those who have high incomes. These borrowers could accelerate gentrification in low- and moderate-income communities.
   
   One solution is for the FHA to insure the piggyback mortgages with the same credit standards as first-lien loans. Insuring a piggyback mortgage is risky for the FHA, and requiring the same mortgagee to service the first and second mortgage could minimize this risk. The process would enable the FHA to look at the two loans as one and help homebuyers with low or moderate incomes access the neighborhoods they want.

Assumable loans are an increasingly attractive option as interest rates rise and, if rates stay high, could play a major role in financing home purchases for years to come. The steps above could help maximize their potential and help buyers with low and moderate incomes compete with cash offers and access homeownership.