Rising Rates Might Lead to Increase in Defect Risk

Mortgage rates are rising and are likely to influence the risk of defect, fraud, and misrepresentation in mortgage loan application according to the First American Loan Application Index that estimates the level of defects detected in the information submitted in mortgage loan applications processed by First American. The index also gauges the frequency with which defects are identified. An increase in the index indicates a rising level of loan application defects.

The study indicated that while the defect index was down 18.6 percent from the high point of risk in October 2013, it had increased 20.3 percent in December 2017 on a year over year basis. For refinance transactions, it remained unchanged compared to the previous month but was 21.1 percent higher than a year ago. Similarly, the Defect Index for purchase transactions remained unchanged compared to the previous month, but rose 12.3 percent on a year-over-year basis.

“We have seen this before, in 2013, as mortgage rates rise, so does overall defect, fraud, and misrepresentation risk,” said Mark Fleming, Chief Economist at First American.

Regionally, Connecticut was the only state indicating a 1.5 percent year over year decrease in defect frequency. At 46.7 percent increase, South Dakota showed the highest year-over-year increase in defect frequency, followed by New Mexico (38.1 percent), Idaho (31.6 percent), North Dakota (31.1 percent), and Nebraska (29.3 percent).

Traditionally, refinance loans have always been less risky than purchase transactions and according to the study, refinance loan transactions are 24 percent less risky than purchase transactions at present. However, the study indicated that rising mortgage rates would reduce the consumer benefit of refinancing their existing loans, so the share of refinance transactions in overall mortgage transactions could decline to 27 percent in 2018.

Citing historical data from 2013, the study indicated that when mortgage rates increased by 1.1 percent between January and September 2013, the overall level of risk in the Defect Index also increased by 7.5 percent.

“Much of the elevated risk can be attributed to an increase in the share of purchase mortgage transactions. It’s possible that all economists agree, that mortgage rates will increase in 2018, which should increase the market share of purchase mortgage transactions, putting upward pressure on the overall risk of defect, fraud, and misrepresentation.”