One of the reasons for the "credit crunch," or tight credit restrictions, during the past few years has been that the government wants to maintain a mortgage marketplace with as little risk as possible. It turns out that this is an enormously complex matter requiring thousands of pages of new rules and guidelines – so far.
"Both market and regulatory uncertainties surrounding the mortgage lending business have kept credit standards tight and prevented a more robust housing market recovery," says a report from Harvard's Joint Center for Housing Studies.
But what does this mean for VA borrowers?
Because of the tight credit restrictions, many borrowers have had to scramble for financing. But for VA borrowers, the story is substantially different. Standards approved by the VA are automatically acceptable under the new rules from Washington.
Why do VA mortgages have such leeway?
The answer has much to do with risk. According to the Mortgage Bankers Association, VA loans are the least-likely form of home financing to involve foreclosures. If you want low-risk mortgages then look at the financing available to vets and military families.
All of this seems counter-intuitive: The VA loan program succeeds without requirements for big down payments or soaring credit scores, the very things now demanded by many lenders.
For instance, there have been calls to raise down payments for FHA financing from 3.5 percent to a full 5 percent, and yet VA loans require nothing down.
Another idea is to have stiffer credit requirements. At the start of 2013, the typical FHA borrower had a credit score of nearly 700. Meanwhile, VA borrowers with credit scores of 620 have good access to financing.
The secret with VA mortgages seems to be the way such loans are underwritten. The VA surely wants good credit and evidence that borrowers can repay their loans, but VA-backed loans also have a "residual income" requirement.
In plain language what this means is that when you apply for a VA loan the lender has to make sure you have income above your housing costs. How much you need depends on such factors as how much you're borrowing, where you live and the size of your household.
Mortgage borrowers today are finding that virtually all loans outside the VA program limit monthly housing expenses and other debts to 43 percent of the applicant's income. Some in the housing industry want to raise this percentage so more people can qualify for financing but the VA already has a solution — the residual income factor. It allows VA borrowers to devote more of their income to monthly costs — but only if they can plainly afford to do so.
The VA is obviously getting good results with the residual income approach. Given the ongoing need for real estate financing — and given the need to restore the housing market — it's amazing that the VA underwriting standard is not adopted more widely.