Here's one big reason it's so darn hard to refinance your home

Magnifying glass on mortgage application form

Have you been turned down for a mortgage when you thought you were more than qualified?

“Defensive lending” is probably to blame.

Many homeowners have checked out the lending requirements for one of the federal government’s many refinance programs and figured they were good to go.

But when they applied at a bank or mortgage company, they were suddenly confronted with demands for higher credit scores, a better debt-to-income ratio or more equity than they’d expected.

That’s because what you see on government websites are the minimum lending standards banks and mortgage companies must follow. They’re allowed to impose stricter rules if they wish – and many do.

The stiffer requirements, known as lender or credit “overlays,” are the hallmark of defensive lending – and a huge problem for all of us.

“Overlays are standing between hundreds of thousands of homeowners and today’s low mortgage rates,” says Dan Green, a loan officer with Waterstone Mortgage in Cincinnati and the author of The Mortgage Reports, a leading consumer mortgage blog.

Lenders even have been placing these hurdles on the Federal Housing Administration’s Streamline Refinance program, which is supposed to allow virtually anyone with an FHA loan to qualify for a new, cheaper mortgage almost automatically.

“Homeowners are hearing about these great programs,” Green says, “and there’s a disconnect between what they’re hearing and what lenders will actually do.”

Fannie Mae and Freddie Mac, the government-owned companies that provide banks with much of the money they lend for mortgages, also have programs intended to help homeowners refinance into lower cost loans.

The one almost everyone has heard of is the Home Affordable Refinance Program, commonly referred to as HARP, which allows homeowners to refinance into low mortgage interest rates even if they’re underwater and owe more than their property is currently worth.

Fannie Mae and Freddie Mac will accept FICO credit scores in the range of 660 to 680, while FHA will approve applications with scores as low as 580. But higher credit scores are a common overlay. Some mortgage providers have been requiring scores as much as 100 points higher.

The overlay problem is serious enough that the FHA and the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, are working with mortgage bankers to see how they might address it.

Until they do, credit overlays will remain a drag on both the housing market and the economic recovery. After all, every point that a homeowner or home buyer can save on a mortgage means additional dollars in their pockets to spend on other things.

For many struggling homeowners, lower payments can mean the difference between being able to stay current on their mortgages and holding onto their homes.

David Stevens, president and CEO of the Mortgage Bankers Association, says lenders recognize that credit overlays are making it difficult for many people to refinance. But he says the stricter standards are a reaction to today’s lending realities.

The first is that the housing market collapse that led to a wave of foreclosures and delinquencies has left mortgage providers gun-shy when it comes to marginal borrowers.

“We’ve learned through hard experience that just because it’s a qualifying loan doesn’t mean it’s going to be a performing loan,” Stevens says.

The attitude of today’s mortgage providers has been described as “defensive lending,” a characterization Stevens calls accurate.

“The mission now is to make sure you’re not doing bad loans,” he says. “It’s a natural consequence of where we’ve been.”

Nine out of 10 mortgages in the United States are backed or finally acquired by Fannie Mae, Freddie Mac or the FHA. But the loans are written by private mortgage providers, who are responsible for accepting the application and accurately filling out the all the paperwork.

If a loan goes into default, and the government finds mistakes or infractions in the documentation, the mortgage provider can be held liable by Fannie or Freddie and forced to buy back the loan. In the case of the FHA, providers can find the government no longer guaranteeing the loan. These penalties can cost lenders hundreds of thousands of dollars.

Stevens say it’s the fear of this legal liability, more than anything, that is causing mortgage providers to add credit overlays that make it more difficult for applicants to qualify.

What mortgage providers would like to see, he says, is “clear rules of the road” on what will be grounds for buybacks going forward. Minor errors that aren’t germane to the reason the loan failed shouldn’t be reason enough to force a mortgage provider to buy back a loan, Stevens adds.

The bankers would also like a limitation on how long they can be held liable for a loan that fails. Some mortgage companies have faced buyback demands for loans that went into default after five or more years of on-time payments.

Some consumer advocates believe lenders have swung too far in the direction of caution, especially in the case of FHA loans.

“These loans are backed by the taxpayer; they should not be making them harder for taxpayers to get,” says Kathleen Day, spokeswoman for the Center for Responsible Lending, a nonprofit Washington group that works to protect homeownership.

She fears mortgage providers are asking the government to take them off the hook when it’s their responsibility to do accurate underwriting for a loan. She also believes they underestimate the American homeowner.

“I challenge the idea of it as defensive,” says Day. “Is it defensive or is it offensive – offensive in the sense of being insulting? People want to stay in their homes. They want to own a home. All the evidence shows people make their mortgage payments if they possibly can.”

A spokesperson for the Federal Housing Finance Agency declined to comment on credit overlays. But Lemar Wooley, a spokesman for the Department of Housing and Urban Development, which includes the FHA, says the agency recognizes there’s a problem.

“FHA intends to work with the lender community to clarify guidelines and oversight in an effort to improve alignment between FHA and lender requirements,” says Wooley.

Wooley said there’s no timeline for a deal, but Stevens believes the government and mortgage brokers will find common ground in the near future. “I feel fairly confident that we’ll soon see some substantial changes made,” Stevens says.

But until that day, thousands of homeowners eager to take advantage of a historic moment in mortgage rates are likely to remain frustrated.

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