Should FHA Loan Limits Be Raised?

October 11, 2001, March 30, 2009

Note: The loan limits were finally raised to equal those of Fannie Mae and Freddie Mac in 2008/2009 as a crisis measure, see FHA Mortgages: a 2009 Update. The remainder of this article remains as I wrote it in 2001.

"Periodically, legislation is introduced in Congress to raise FHA loan limits to those applicable to Fannie Mae and Freddie Mac.  Is this a good idea?"

No. The result would be a rise in FHA losses, followed by an increase in mortgage insurance premiums. This would hurt FHA's current clientele of low-income borrowers, and especially minority borrowers.

The FHA program began in the depths of the depression of the 1930s when lenders had stopped making new loans because default and foreclosure rates on old loans had reached 20-30%. The FHA's objective was to induce lenders to start lending again by insuring them against loss in the event the borrower defaulted. The program was designed to be self-supporting, with FHA collecting insurance premiums from borrowers sufficient to offset losses. While some special FHA programs are directly subsidized by the Government, the major program to which the proposal applies has always been self-supporting.

The program worked so well in the first two decades that it stimulated the development of private mortgage insurance companies (PMIs) in the mid-50s. The FHA served the lower end of the market while PMIs served the higher end, with some overlap in the middle. For a long period, both prospered because property values were rising and defaults were few. But when real estate prices stopped rising in the late 80s, both FHA and the PMIs suffered serious losses. FHA was obliged to raise insurance premiums substantially while the PMI industry consolidated into a smaller number of stronger companies.

Today the FHA program primarily serves borrowers who cannot meet conventional down payment requirements, or have a credit history that is not acceptable to PMIs. (See Who Should Take an FHA?)

The reason a rise in the maximum FHA loan would increase losses is that, on low-down payment loans, larger loans have higher default rates than smaller ones. The likely reason for this is that prices of more expensive homes fluctuate more, and the more sophisticated borrowers who take out larger loans are more likely to walk away if the equity in their homes disappears.

In addition, the share of FHA loans that meet PMI requirements will be smaller on larger loans, because higher-income borrowers are less vulnerable to being "steered" to FHA. Since FHA must be self-supporting, the result will be an increase in insurance premiums on all FHA borrowers, including the low-income and minority clients who ought to be the agency's primary concern.

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