Higher risk of purchase mortgage application defects as market shifts

The drop in home buying power heightened the risk of misrepresentations on purchase mortgage loan applications during November, as consumers are more willing to fudge information in an uncertain market, First American Financial said.

For the first time since March, the purchase component of the First American Loan Defect Index increased from the previous month, as it rose by 2.7%. Compared with November 2018, the index was 8.3% lower.

At the same time, the refinance component decreased by 1.6% from October and by 17.8% from the previous year.

Because of the offset, the total index remained unchanged from October, at 68. It is 16% lower than the same month in 2018, when the index was 81. The index peaked at 95 in February and March, and November was the first month since then when the overall index did not decline.

Applications defects are a red flag for the possibility of the existence of mortgage fraud in a loan file.

There are two reasons for the flattening of the total index and the change in direction for the purchase component, said First American Chief Economist Mark Fleming in a press release.

"When house buying power — i.e., how much home one can buy based on changes in household income and interest rates — falls in a supply-constrained market fraud risk may increase. Potential homebuyers feel more confident and less inclined to commit fraud when they are in a better financial position to purchase a home," said Fleming. "While house buying power remains high, the pace of growth slowed beginning in October, when mortgage rates began to inch up."

For the first nine months of the year, home buying power grew by at an average monthly rate of 1.6%. But over the next two month, that fell by 0.6% compared with September.

"The slowdown in house buying power appreciation lessens the confidence of homebuyers, so they may be more inclined to misrepresent information on a loan application, leading to an increase in the defect index for purchase transactions," Fleming said.

Meanwhile, in November, refinance application activity fell by 8% from the same month in 2018. At the same time, purchase application volume rose 7%. "Defect, fraud and misrepresentation risk is significantly lower on refinance transactions, so the increased share of higher-risk purchase activity halted the decline in the overall defect index," said Fleming.

Even with the shift in the market at the end of 2019, the defect risk for next year will be most influenced by whether mortgage rates stay below 4%, as industry economists expect.

"At that level, there are still 6.8 million borrowers today who could benefit financially by refinancing to a lower mortgage rate," said Fleming. "As a result, the direction of defect risk in 2020 is in large part dependent on mortgage rates and how many homeowners that are 'in the money' choose to refinance."