Here Come Cheap Mortgages for Millennials. Should We Worry?

According to new research from Trulia, in metro areas teeming with millennials, such as Austin, Honolulu, New York, and San Diego, more than two-thirds of the homes for sale are out of reach for the typical millennial household.

That goes a long way to explaining why first-time homebuyers have recently accounted for about one-third of homes sales, according to the National Association of Realtors, down from a historic norm of about 40%. And it should concern you even if you’re not a millennial or related to one: A shortage of first-time buyers makes it harder for households that want to trade up to find potential buyers; and spending by homeowners for homes and housing-related services accounts for about 15% of GDP.

Now the federal government appears intent on reversing the trend -- or at least on easing the pain of the still-sluggish housing industry.

Trulia's dire analysis assumes that buyers need to make a 20% down payment -- a high hurdle for anyone, let along a younger adult. But Fannie Mae and Freddie Mac, the government agencies that guarantee the vast majority of mortgages, this week launched new loan options that will require down payments of as little as 3% for first-time buyers (and, in limited instances, refinancers as well). Fannie’s program will be live next week; Freddie’s, which will be available to repeat buyers as well, will launch in early spring.

Before you get all “Isn't that the sort of lax standard that fueled the financial crisis!?”, it’s important to realize significant differences between now and then.

The only deals that will qualify for the 3%-down programs are plain-vanilla 30-year fixed-rate loans. No adjustable-rate deals, no teaser-rate come-ons, and, lordy, no interest-only payment options. And flippers are not welcome; the home must be the borrower’s principal residence.

Both Fannie Mae's MyCommunityMortgage and Freddie Mac’s Home Possible Mortgage program are aimed at moderate-income households. For example, to qualify for Fannie Mae’s program, household income must typically be below the area median. Income limits are relaxed a bit in some high cost areas, such as the State of California (up to 140% of the local median) and pricey counties in New York (165% of the median).

That said, lenders will be allowed to extend these loans to borrowers with credit scores as low as 620. That’s even lower than the average 661 FICO credit score for Federal Housing Administration-insured loan applications that were turned down in October, according to mortgage data firm Ellie Mae. (The average FICO credit score for FHA approved loans was 683.)

Like FHA-insured loans, the new 3% mortgages offered by Fannie and Freddie will require home buyers have private mortgage insurance (PMI). That can add significantly to mortgage costs.

For example, a $300,000 home purchased with a 3.5% fixed rate loan and a 3% down payment would have monthly principal and interest charges of about $1,300 a month. The PMI adds another $240 or so to the monthly cost; that’s nearly 20% of the base monthly mortgage amount. (You can estimate the bite of PMI using Zillow’s Mortgage Calculator.)

But one significant advantage the new Fannie/Freddie loan programs have over the FHA program is that they will allow homeowners to cancel their PMI once their home equity reaches at least 20%. Beginning in 2013, the annual insurance charge on FHA-insured loans, currently 1.35% of the loan balance, can never be cancelled regardless of whether the borrower has more than 20% equity.