Over the past several months, the Federal Housing Administration (FHA) and others in the mortgage industry have observed an increase in the number of homeowners who have chosen to vacate their existing principal residences, purport to rent them out, and purchase a new residence. This increase has been attributed by FHA to rising fuel prices resulting in homeowners relocating to houses nearer their employment or taking advantage of more affordable home buying opportunities arising in the marketplace.
Concerns have been raised as some home buyers may attempt to mislead lenders on the rental income of the property being vacated in order to qualify for the new mortgage with the intention of defaulting on the first home as soon as or shortly after the closing on the new home.
Background on ‘Buy and Bail’
The practice of “buy and bail” is where the home buyer purchases (the “buy”), for example, a more affordable dwelling with the intention to cease making payments on the previous home’s mortgage (the “bail”). Among the various reasons for a home buyer to engage in this practice may be they owe the bank more money than the house is worth, they could no longer afford their monthly mortgage payments, or they simply have found a more affordable or nicer home and can’t sell the home they are vacating.
But how can homeowners get a loan for a new home if they are barely able to make their current payments? In many cases, they tell the underwriters they plan to rent out the first house and seek to use that income to qualify for a new mortgage on their new principal residence. In essence, they are trying to qualify and secure the mortgage on the new home before the severely negative consequences the “pending” foreclosure on the first home will have on their credit rating. According to FHA, the practice of “buy and bail” poses a risk to FHA, FHA-approved lenders, and consequently to FHA’s ability to help new homeowners.
On September 19, 2008, FHA released Mortgagee Letter 2008-25, which addresses underwriting instructions for converting existing owner-occupied homes to rentals. The purpose of these news guidelines is to prevent FHA loans from being used in “buy and bail” situations
Converting Existing Homes to Rentals – Underwriting Instructions
For all FHA-insured mortgages issued on and after September 19, 2008, lenders may not consider rental income from the property being vacated in the underwriting process except under specific and limited circumstances. This exclusion policy is being instituted on a temporary basis so FHA can further analyze the situation and determine whether permanent measures need to be taken.
FHA says this measure will assure that a homeowner either has sufficient income to make both mortgage payments without any rental income or has an equity position not likely to result in defaulting on the mortgage on the property being vacated. This policy will help prevent the practice of “buy and bail” by ensuring homeowners retain sufficient means and interest to give them a strong incentive not to “bail” on the initial residence.
Although the property being vacated will not likely have mortgage insured by FHA, FHA is concerned that surrounding properties may, and thus, they may be indirectly negatively affected should that property result in foreclosure, reducing home values throughout the neighborhood.
Exceptions to the Rule
The mortgagee letter describes two exceptions for relocations and vacated homes with sufficient equity in the initial residence. “A homebuyer that is relocating with a new employer or being transferred by the current employer to an area not within reasonable and locally recognized commuting distance” is exempt if they meet the certain additional requirements. A lease agreement of at least one year after the loan is closed is required to qualify. FHA also recommends that underwriters obtain evidence of the security deposit or evidence the first month’s rent was paid to the homeowner. In essence, they want proof the property is being rented and will not approve the mortgage if it isn’t.
Second, a “homebuyer with a loan-to-value ratio of 75 percent or less in the vacated property, as determined by either a current (no more than six months old) residential appraisal or by comparing the unpaid principal balance to the original sales price of the property” will still qualify for an FHA mortgage for the new home. In this case, there is sufficient equity in the vacated residence to serve as a deterrent to bailing from the property. The Mortgagee Letter applies solely to a principal residence being vacated in favor of another principal residence.
Consequences of “Buy and Bail”
While the “buy and bail” solution may seem like a good idea to some, there are repercussions for the homeowner, their communities, and real estate professionals. One problem with this practice is that foreclosure ruins a person’s credit rating. Borrowers lose the ability to take out loans, since foreclosures can stay on a credit report for seven years. Additionally, in some states, lenders can sue for assets, including a new house or even file fraud charges against the borrower.
Real estate professionals should be wary of the practice. First, the lending industry is less likely to look kindly on such a transaction whether the buyer is seeking an FHA loan or not which means the transaction is less likely to close. Second, clients may not be considering the long term consequences to their actions and may find themselves in unforeseen future difficulties both financial and legal. Finally, real estate professionals will want to consider the impact on local markets. Today’s client’s actions might hurt future customer’s ability to buy and sell homes in the area and that is not good for anyone. While, renting out one’s former principal residence is a good way to facilitate a move in a slow market, bailing out on that residence and its mortgage is not.
As you examine the housing crisis, you’ll realize that it is not a simple problem and that there’s no simple cure. Only after more sound business practices take hold will we see an overall improvement. Unfortunately for many 1st time home buyers, the availability of non-conventional mortgages is limited and they are suffering for the lax practices we’ve seen over the past few years.
Parts of this were published in an article by Kenneth Trepeta, director of Real Estate Services at the National Association of Realtors®.
