The federal government's largest home finance program might soon offer consumers a range of options they've never had before: mini-downpayments, lower than 3 percent, scaled all the way down to zero.

To do that, however, the Federal Housing Administration (FHA), wants Congress to allow it to use electronic "risk-based pricing" for the first time in its 72 year history. Risk-based pricing has been used in the private mortgage marketplace since the mid-1990s, when Fannie Mae and Freddie Mac introduced their Desktop Underwriter and Loan Prospector systems.

All risk-based pricing involves electronic credit checks and credit scores, ordered and obtained in seconds from the national credit bureaus. The risk-based system then prices the mortgage according to the probability of future default posed by the applicant and the size of the downpayment. Applicants with shaky credit and very low downpayments tend to get quoted higher interest rates and loan fees than applicants with better credit.

Virtually alone among major players in the U.S. home loan market, FHA never has adopted risk-based pricing for the premiums it charges for its mortgage insurance. Nor does it use applicants' FICO scores for underwriting or pricing purposes. Instead it has pursued a "cross-subsidization" approach whereby loan applicants with better credit pay slightly higher premiums than they "deserve" on the basis of default risk, while borrowers with lower quality credit pay less than they "deserve" on a risk-adjusted basis.

But now the Bush administration's new budget proposes to chuck the traditional cross-subsidization approach out the window and replace it with risk-based pricing.

The reason? Many of FHA's applicants with better credit profiles have abandoned the program in recent years, wooed away by fast-growing subprime competitors in the private sector. The White House estimates that 70 percent of FHA's business has shifted elsewhere during the past three years alone. Subprime firms using risk-based pricing have been able to offer FHA's lowest-risk home buyers attractive rates and fees -- a "creaming" process that threatens to leave the agency with a higher-risk overall book of insurance business.

FHA's chief operating officer, federal housing commissioner Brian D. Montgomery, said in an interview that "we are losing our core group of customers" in part because the agency cannot offer rates and downpayment levels on a risk-based sliding scale.

"We need to get out of the one-size-fits-all approach because one size no longer fits all," said Montgomery. "We need to spread out our risk and price differently." Specifically, FHA wants to offer downpayments below the standard 3 percent and lower insurance premiums to applicants with lower risk of default. On the flip side, it would offer slightly higher premiums -- generally no higher than one half of one percent higher -- to applicants who offer elevated risks of default based on their prior credit histories.

Combined with FHA's substantially higher loan limits -- up to $362,790 for 2006 in high cost areas -- the zero-down, risk-based pricing approach could help turn around FHA's declining mortgage insurance volume. That, in turn, could be very good news for the moderate-income and minority first-time home buyers who are FHA's traditional market mainstays.

Published: February 20, 2006

Use of this article without permission is a violation of federal copyright laws.

Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consmer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.