[Federal Register Volume 71, Number 33 (Friday, February 17, 2006)]
[Proposed Rules]
[Pages 8523-8543]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 06-1349]


 ========================================================================
 Proposed Rules
                                                 Federal Register
 ________________________________________________________________________
 
 This section of the FEDERAL REGISTER contains notices to the public of 
 the proposed issuance of rules and regulations. The purpose of these 
 notices is to give interested persons an opportunity to participate in 
 the rule making prior to the adoption of the final rules.
 
 ========================================================================
 

  Federal Register / Vol. 71, No. 33 / Friday, February 17, 2006 / 
Proposed Rules  

[[Page 8523]]



DEPARTMENT OF AGRICULTURE

Rural Housing Service

7 CFR Part 3550

RIN 0575-AC59


Single Family Housing Loans, Payment Assistance

AGENCY: Rural Housing Service, USDA.

ACTION: Proposed rule.

-----------------------------------------------------------------------

SUMMARY: The Rural Housing Service (RHS) proposes to amend its 
regulations for Single Family Housing Loans. This action proposes to 
amend only the amount of payment assistance for which a borrower 
qualifies. This action is taken to improve distribution of program 
benefits, simplify the application process, and improve customer 
service.

DATES: Written or e-mail comments must be received on or before April 
18, 2006.

ADDRESSES: You may submit comments to this rule by any of the following 
methods:
     Agency Web site: http://www.rurdev.usda.gov/regs/. Follow 
the instructions for submitting comments on the Web site.
     E-Mail: [email protected]. Include the RIN number 
(0575-AC59) in the subject line of the message.
     Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     Mail: Submit written comments via the U.S. Postal Service 
to the Branch Chief, Regulations and Paperwork Management Branch, U.S. 
Department of Agriculture, STOP 0742, 1400 Independence Avenue SW, 
Washington, DC 20250-0742.
     Hand Delivery/Courier: Submit written comments via Federal 
Express Mail or another mail courier service requiring a street address 
to the Branch Chief, Regulations and Paperwork Management Branch, U.S. 
Department of Agriculture, 300 7th Street, SW., 7th Floor, Suite 701, 
Washington, DC 20024.
    All written comments will be available for public inspection during 
regular work hours at the 300 7th Street, SW., address listed above.

FOR FURTHER INFORMATION CONTACT: Michael S. Feinberg, Chief, Loan 
Origination Branch, Rural Housing Service, USDA, Ag Box 0783, Room 
2214, 1400 Independence Avenue, SW., Washington, DC 20250-0783. 
Telephone: 202-720-1474.

SUPPLEMENTARY INFORMATION:

Classification

    This rule has been determined to be significant by the Office of 
Management and Budget (OMB) under Executive Order 12866 and has been 
reviewed by OMB.

Regulatory Flexibility Act

    In compliance with the Regulatory Flexibility Act (5 U.S.C. 601-
602), the undersigned has determined and certified by signature of this 
document that this rule will not have a significant economic impact on 
a substantial number of small entities. This rule does not impose any 
new requirements on Agency applicants and borrowers and the regulatory 
changes affect only Agency determination of program benefits for 
individual loans.

Environmental Impact Statement

    This document has been reviewed in accordance with 7 CFR part 1940, 
subpart G, ``Environmental Program.'' It is the determination of RHS 
that this proposed action does not constitute a major Federal Action 
significantly affecting the quality of the human environment, and in 
accordance with the National Environmental Policy Act of 1969, Public 
Law 91-190, an Environmental Impact Statement is not required.

Unfunded Mandates Reform Act

    Title II of the Unfunded Mandates Reform Act of 1995 (UMRA), Public 
Law 104-4, establishes requirements for Federal agencies to assess the 
effects of their regulatory actions on State, local, and tribal 
governments and the private sector. Under section 202 of the UMRA, the 
Agency generally must prepare a written statement, including a cost-
benefit analysis, for proposed and final rules with ``Federal 
mandates'' that may result in expenditures to State, local, or tribal 
governments, in the aggregate, or to the private sector, of $100 
million or more in any one year. When such a statement is needed for a 
rule, section 205 of the UMRA generally requires the Agency to identify 
and consider a reasonable number of regulatory alternatives and adopt 
the least costly, more cost-effective or least burdensome alternative 
that achieves the objectives of the rule.
    This rule contains no Federal mandates (under the regulatory 
provisions of Title II of the UMRA) for State, local, and tribal 
governments or the private sector. Therefore, this rule is not subject 
to the requirements of sections 202 and 205 of the UMRA.

Executive Order 13132

    The policies contained in this rule do not have any substantial 
direct effect on States, on the relationship between the national 
government and States, or on the distribution of power and 
responsibilities among the various levels of government. Nor does this 
rule impose substantial direct compliance costs on State and local 
governments. Therefore, consultation with the States is not required.

Programs Affected

    This program is listed in the Catalog of Federal Domestic 
Assistance under No. 10.410, Low Income Housing Loans.

Intergovernmental Consultation

    For the reasons set forth in the final rule related Notice to 7 CFR 
part 3015, subpart V, this program is excluded from the scope of 
Executive Order (E.O.) 12372, which requires intergovernmental 
consultation with State and local officials.

Civil Justice Reform

    This proposed rule has been reviewed under Executive Order 12988, 
Civil Justice Reform. In accordance with this Executive Order: (1) All 
State and local laws and regulations that are in conflict with this 
rule will be preempted, (2) no retroactive effect will be given to this 
rule, and (3) administrative proceedings in accordance with the 
regulations of the Agency at 7 CFR part 11 must be exhausted before 
bringing litigation challenging action taken under this rule.

Paperwork Reduction Act

    The information collection requirements contained in these 
regulations have been approved by OMB

[[Page 8524]]

under the provisions of 44 U.S.C. chapter 35 and have been assigned OMB 
control numbers 0575-0172 in accordance with the Paperwork Reduction 
Act. This proposed rule does not revise or impose any new information 
collection requirements from those mentioned above.

GPEA Statement

    RHS is committed to compliance with the Government Paperwork 
Elimination Act (GPEA), which requires Government agencies, in general, 
to provide the public the option of submitting information or 
transacting business electronically to the maximum extent possible.

Background

    The U.S. Department of Agriculture's (USDA's) Rural Housing Service 
(RHS) is proposing to revise the regulations for Direct Single Family 
Housing Loans. This action is being taken to improve distribution of 
payment assistance subsidies to its section 502 Single Family housing 
direct loan program borrowers and simplify the formula for determining 
the level of payment assistance granted to new borrowers.

Economic Impact Analysis

    USDA contracted for a study of its payment assistance formula 
including the development of alternatives. This study is available for 
public inspection during working hours at Room 2214, 1400 Independence 
Avenue, SW., Washington, DC 20250-0783. Telephone: 202-720-1474. In its 
study of alternatives to the current payment assistance formula, RHS 
began with the premise that a new payment assistance formula must not 
increase the cost of the program (be subsidy neutral) and must serve 
the same target population. These conditions assure that there would be 
no significant economic impact resulting from a revision of the formula 
for payment assistance. The program will continue to assist very low- 
and low-income, rural residents to improve their living conditions and 
economic situation by building equity through homeownership. Based on 
an average loan in the range of $83,000 per home, for each $1.0 billion 
in program level, RHS provides financing for over 12,000 single-family 
homes. This investment is instrumental in creating over 14,000 direct 
and indirect jobs. Assuming an average salary of $20,000 per job 
created, $280 million in purchasing power is generated. Additionally, 
these jobs also generate additional tax revenue for Federal, State, and 
local governments, as well as aid in the stabilization or redevelopment 
of neighborhoods.
    However, the proposed change will affect the level of payment 
assistance received by all new borrowers (in 2003 over 12,500) 
following the effective date of the rule, and for that reason, the 
proposed action has been determined to be significant. The effect of 
the proposed rule compared to that of the current formula and the other 
alternatives considered is discussed in detail below.

Discussion

    During fiscal year 2004, RHS studied its payment assistance formula 
for the Direct section 502 Single Family Housing program and concluded 
that changes were needed.

Current Formula

    RHS administers the single-family housing direct loan program 
authorized in section 502 of the Housing Act of 1949, as amended (42 
U.S.C. 1472). The program provides loans to low- and very low-income 
households to purchase homes in rural areas, generally defined as 
cities, towns, and unincorporated areas with populations of 20,000 or 
less.\1\ These loans provide financing at reasonable rates and terms 
with no down payment required.
---------------------------------------------------------------------------

    \1\ For the purposes of the section 502 program, rural areas are 
statutorily defined in section 520 of the Housing Act of 1949, 42 
U.S.C. 1490 and its implementing regulation, 7 CFR 3550.9.
---------------------------------------------------------------------------

    Pursuant to section 502, eligible families must be without adequate 
housing and unable to obtain credit through the private sector \2\ but 
able to afford the mortgage payments, taxes, and insurance on the 
houses financed by RHS. The interest rate on the loans can be 
subsidized to as low as one percent. Typically, the mortgage payments 
require 24 to 30 percent of an applicant's income. Although a 38-year 
term is available, most loans are issued with a term of 33-years, and 
the majority of homes initially financed by RHS are refinanced through 
conventional mortgages or repaid through property sales within eight to 
ten years.
---------------------------------------------------------------------------

    \2\ Section 501(c) (42 U.S.C. 1471(c)).
---------------------------------------------------------------------------

    For loans made prior to 1995, RHS subsidized using a program called 
``interest credit.'' Borrowers made monthly payments that were the 
greater of (a) 20 percent of adjusted family income; or (b) payments 
based on the loan amortized at a one percent interest rate. RHS 
provided interest credit to make up the difference between this amount 
and the amount of the payment at the note rate.
    One drawback of this method was that it provided little incentive 
for borrowers to shop for an inexpensive home since the borrower's 
payment did not increase significantly as a result of a higher loan 
amount. Another criticism was that it was inequitable. For example, 
families attempting to purchase inexpensive homes were denied 
assistance if the formula did not indicate principal, interest, taxes, 
and insurance (PITI) would exceed 20 percent of adjusted income while 
borrowers who purchased higher cost homes received the maximum level of 
subsidy allowed.
    As a result of these and other limitations, RHS implemented a new 
subsidy program effective October 27, 1995. Under this program called 
``payment assistance,'' the subsidy for each loan is based on the ratio 
of the household's annual adjusted income (AAI) to the area median 
income (AMI), a figure that the U.S. Department of Housing and Urban 
Development (HUD) publishes annually for all U.S. counties. To be 
eligible for payment assistance, household income must be within the 
low-income limit, defined as 80% of AMI. Once payment assistance is 
granted, the household remains eligible for payment assistance in 
accordance with the formula below. The payment assistance amount is the 
difference between the note rate payment and the greater of (a) the 
payment at an equivalent interest rate and (b) the floor payment.
    The equivalent interest rate is derived from a scale based on the 
ratio of the borrower's AAI to AMI, as described in Exhibit 1 below:

[[Page 8525]]



               Exhibit 1.--Equivalent Interest Rate Scale
------------------------------------------------------------------------
                                     When the borrower's adjusted income
                                                     is
                                   -------------------------------------
                                                             Then the
 Equal to or more than  (percent)                           equivalent
                                        But less than      interest rate
                                                               is *
                                                             (percent)
------------------------------------------------------------------------
0.0...............................  50 percent of AMI...               1
50................................  55 percent of AMI...               2
55................................  60 percent of AMI...               3
60................................  65 percent of AMI...               4
65................................  70 percent of AMI...               5
70................................  75 percent of AMI...               6
75................................  80 percent of AMI...             6.5
80................................  90 percent of AMI...             7.5
90................................  100 percent of AMI..             8.5
100...............................  110 percent of AMI..             9.0
110...............................  or more than AMI....            9.5
------------------------------------------------------------------------
* Or note rate, whichever is less. In no case will the equivalent
  interest rate be less than 1 percent.

    The floor payment is also based on the ratio of the borrower's AAI 
to the AMI and is scaled to a minimum percentage of income that a 
borrower must pay for PITI.
    Exhibit 2 shows this scale:

                     Exhibit 2.--Floor Payment Scale
------------------------------------------------------------------------
                                                              Minimum
                                                           percentage of
                                                            AAI that a
               AAI as a percentage of AMI                  borrower must
                                                           pay for PITI
                                                             (percent)
------------------------------------------------------------------------
0.0 percent to 50 percent...............................              22
50.01 percent to 65 percent.............................              24
65.01 percent to 80 percent.............................              26
------------------------------------------------------------------------

    The following is the step-by-step process for determining a 
borrower's eligibility for payment assistance under the current 
formula, and the amount of payment assistance for which he or she 
qualifies, using the assumptions below:
     Borrower Assumptions:
    [cir] AAI: $19,000
    [cir] AMI: $30,000
    [cir] Is the borrower eligible? Yes, because AAI is 63 percent of 
AMI and the eligibility threshold is 80 percent.
     Loan Assumptions:
    [cir] Initial Principal Amount: $60,000
    [cir] Loan Term: 33 Years
    [cir] Market Rate: 7 percent
    [cir] Monthly Taxes and Insurance: $90.00 (1.8 percent of Initial 
Principal/12 Months).

   Exhibit 3.--Application of the Payment Assistance Formula Using the
                            Above Assumptions
------------------------------------------------------------------------
              Explanation                          Calculation
------------------------------------------------------------------------
How Much Does the Borrower Pay to USDA
 for Principal and Interest Cost?
The borrower pays the higher of the
 following two calculations:
First Calculation:
    Based on the ratio of Borrower AAI   Applicable Interest Rate at 63%
     to AMI (Exhibit 1), the borrower's   AAI to AMI Ratio yields 4%
     interest rate will be 4 percent,     equivalent interest rate (from
     which equates to a monthly payment   chart).
     of $273.00.
Second Calculation:
    The Floor Payment for principal and  Initial Principal Amount
     Interest (This is the fixed          $60,000 @4% for 33 years =
     percentage of borrower income or     $273.00.
     the minimum the borrower is
     required to pay to USDA).
    Applicable floor payment percentage  Applicable percentage for 63%
     for PITI = 24 percent.               AAI to AMI ratio.
    Monthly Floor Payment = $380.......
    Monthly Floor Payment for principal  24% of AAI ($19,000) divided by
     and interest = $290.                 12 months.
    The borrower pays at Floor Payment   PITI of $380 minus T&I of $90.
     for principal and interest = $290.  The higher of the two
                                          calculations.
    How much would the borrower pay at   $389 ($60,000 amortized @7% for
     the Note Rate of 7%? $389.           33 years).
    Payment Assistance received from     $389 - $290 = $99.
     USDA = $99.
------------------------------------------------------------------------

    Recently, RHS began to examine anecdotal evidence that suggested 
the current formula caused anomalies in the distribution of payment 
assistance to borrowers, was complicated and difficult to explain, and 
had other unintended consequences, such as encouraging borrowers to 
purchase more expensive housing to qualify for increased payment 
assistance.
    RHS engaged a contractor with extensive experience in Federal 
housing programs and other lending programs to:
     Assess the extent to which the current formula results in 
unintended treatment of borrowers;
     Examine formulas used in other mortgage assistance 
programs; and
     Develop a simpler and more equitable alternative that 
would not result in increased cost to the Government but would continue 
to serve the same target market.
    RHS presented the findings and preliminary alternatives to a panel 
of

[[Page 8526]]

rural housing industry leaders and obtained their feedback. RHS then 
further analyzed two potential alternatives to the current formula. The 
results of these analyses follow.

Assessment Based on Historical and Sensitivity Analyses

    The assessment RHS commissioned included a sensitivity analysis of 
the factors that comprise the payment assistance formula; a historical 
analysis of 219,218 loans closed between October 26, 1995 and November 
5, 2003; and research on other affordable single-family housing loan 
programs. Affordable single-family programs researched include programs 
offered by the Department of Housing and Urban Development, State 
agencies, and non-government entities. The historical analysis 
summarized borrower and loan characteristics and used the theoretical 
findings of the sensitivity analysis to evaluate whether borrowers with 
similar income characteristics received different levels of payment 
assistance. The results of the historical analysis support the 
theoretical findings of the sensitivity analysis.

Summary of Loan Characteristics

    Of the 219,218 loans, 70 percent (152,830 loans) were non-leveraged 
loans, and 151,107 of those were analyzed. Leveraged loans were 
analyzed and will be discussed separately below because of the way the 
Agency considers these loans for payment assistance. The balance of the 
non-leveraged loans were excluded because of missing data. Of the 
151,107 observations, 54 percent of the borrowers have housing costs at 
or below 26 percent of their AAIs.
    Exhibit 4 presents loan characteristics of borrowers based on 
payment calculation methods: Effective interest rate (EIR) and floor 
payment.

                                                Exhibit 4.--Key Characteristics of RHS 502 Direct Loan Borrowers (Non-Leveraged Loan Agreements)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                                                                        Average
                                                                                                                                                                                        borrower
                                                                                                                  Average                                         Average    Average   PITI cost
                                                                                 Percent    Average    Average     AAI as    Average    Average      Average      payment    borrower     with
                     Payment calculation method                        Count     of total     AAI        AMI      percent      EIR      initial     borrower    assistance      PI      assist.
                                                                                                                   of AMI              principal  contribution     amt.      portion       as
                                                                                                                                                                                        percent
                                                                                                                                                                                         of AAI
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
EIR................................................................     95,248         62    $14,102    $38,348         38       1.61    $77,587         $260         $236         52         47
Floor..............................................................     57,582         38     20,439     41,080         50       2.09     70,329          310          142         69         25
                                                                    ------------
    Total/Avg......................................................    152,830        100     16,489     39,377         42       1.79     74,852          279          201         58         39
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

    The table shows that 62 percent of the borrowers have principal and 
interest payments based on the EIR. These borrowers have lower annual 
adjusted incomes, live in areas with lower area median incomes, and 
have higher initial principal amounts, all of which cause their total 
housing cost to average 47 percent of their income, as opposed to a 
portfolio average of 39 percent. Conversely, borrowers with higher 
incomes pay only 25 percent of their incomes toward housing costs.

Historical and Sensitivity Analyses

    Four factors determine the payment assistance amount that RHS 
Single Family housing direct loan program borrowers receive: (1) AMI, 
(2) borrower's AAI, (3) the initial principal amount of the loan, and 
(4) taxes and insurance cost. The purpose of the sensitivity analysis 
was to evaluate how changes in each of the four factors affect the 
borrower's contribution and the level of payment assistance, holding 
the other three factors constant. The baseline assumptions for this 
analysis represent a typical 502 loan and are used as examples in the 
RHS section 502 servicing handbook. They are as follows:
     Borrower's AAI: $19,000
     AMI: $30,000
     Initial Principal Amount: $60,000
     Loan Term in Years: 33
     Market Rate: 7 percent
     Monthly Taxes and Insurance: $90 (1.8 percent of Initial 
Principal Amount/12 months)
    The results of the sensitivity analyses are as follows. Where 
relevant, historical data has also been included.

Changing AMI, Holding Other Factors Constant

    An RHS borrower who decides to buy a home in a county with a lower 
median income receives less payment assistance than he or she would in 
a higher income county, even when the home price, taxes, and insurance 
are exactly the same in the two counties. Similarly, when an RHS 
borrower whose income stays constant lives in a county where the AMI 
increases, he or she receives additional payment assistance; and if the 
county's economy declines and the AMI drops, he or she receives less 
payment assistance. This occurs because payment assistance is 
determined by the ratio of the borrower's AAI to the county's AMI.
    The actual examples in Exhibit 5 illustrate the way in which AMI 
skews the amount of payment assistance a borrower receives, all other 
factors being equal. The first example shows this dynamic by examining 
two borrowers in different counties. The second example shows what 
happens to the amount of payment assistance a borrower receives from 
one year to the next when income stays constant but county AMI changes.

                                       Exhibit 5.--Impact of Changes in AMI on Payment Assistance, Current Formula
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                              Initial      Adjusted       Area       AAI as a                  Payment
       Example                 Borrower               County and state       principal      annual       median     percent of    Original    assistance
                                                                               amount       income       income        AMI          PITI        amount
--------------------------------------------------------------------------------------------------------------------------------------------------------
1....................  A.......................  Kingfisher County, OK....      $56,000      $20,440      $31,300           65         $446           $4
                       B.......................  Suffolk County, VA.......       56,000       20,440       44,400           46          446           70
                                                ----------------------------
                       Difference..............  .........................  ...........  ...........       13,100  ...........  ...........           66
2....................  C.......................  Tulare County, CA........       54,431       19,330       38,600           50          425           39
                       D.......................  Tulare County, CA........       54,431       19,330       39,200           49          425           71
                                                ----------------------------

[[Page 8527]]

 
                       Difference..............  .........................  ...........  ...........          600  ...........  ...........           32
--------------------------------------------------------------------------------------------------------------------------------------------------------

    In addition to showing the discrepancies in payment assistance for 
similar borrowers under the current formula, these examples highlight 
the formula's inefficiencies. In Example 1, the borrower in the lower 
income county receives considerably less payment assistance-in this 
case, Borrower A receives 17.5 times less assistance than Borrower B, 
yet their AAI is identical. Example 2 shows how small changes in AMI 
can lead to significant changes in payment assistance. The AMI in 
Tulare County increased by 1.5 percent from one year to the next, yet 
Borrower C's payment assistance increased by 82 percent. Even if the 
cost of living increased with the rise in AMI, it is unlikely that 
Borrower C needed an 82 percent increase in assistance in order to 
adjust to this change.
    The historical analysis found that a difference of $244 was the 
largest difference in the amount of payment assistance two borrowers 
received who had the same incomes, principal amount, and taxes and 
insurance. The smallest difference was $14.

Changing AAI, Holding Other Factors Constant

    Two noteworthy phenomena occur when AAI changes while the other 
three factors are held constant: First, borrowers who pay the 
equivalent interest rate (those with very low incomes) receive a fixed 
amount of payment assistance, regardless of income; while those who pay 
based on the floor payment receive payment assistance that varies with 
their income.
    Exhibit 6 illustrates this result.

                                              Exhibit 6.--Impact of Changes in Income on Borrower's Payment and Payment Assistance, Current Formula
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                                                                      Borrower's
                                                                                                                                                                        Borrower's    PITI cost
                                                                AAI as a     Applied                                 Floor                   Borrower's                    PITI          with
                             AAI                               percent of   percent of  Applied EIR    Original    payment of   Payment  @       P&I       Assistance  contribution   assistance
                                                                  AMI         floor      (percent)    total PITI      P&I          EIR      contribution     amount       portion        as a
                                                                             payment                                                                                     (percent)    percent of
                                                                                                                                                                                         AAI
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
$13,000.....................................................           44           22            1          479          148          178           178          211            56           25
$13,300.....................................................           45           22            1          479          154          178           178          211            56           24
$13,600.....................................................           46           22            1          479          159          178           178          211            56           24
$13,900.....................................................           47           22            1          479          165          178           178          211            56           23
$14,200.....................................................           48           22            1          479          170          178           178          211            56           23
$14,500.....................................................           49           22            1          479          176          178           178          211            56           22
$14,800.....................................................           50           22            1          479          181          178           181          208            57           22
$15,100.....................................................           51           24            2          479          212          207           212          177            63           24
$15,400.....................................................           52           24            2          479          218          207           218          171            64           24
$15,700.....................................................           53           24            2          479          224          207           224          165            66           24
$16,000.....................................................           54           24            2          479          230          207           230          159            67           24
$16,300.....................................................           55           24            2          479          236          207           236          153            68           24
$16,600.....................................................           56           24            3          479          242          239           242          147            69           24
$16,900.....................................................           57           24            3          479          248          239           248          141            71           24
$17,200.....................................................           58           24            3          479          254          239           254          135            72           24
$17,500.....................................................           59           24            3          479          260          239           260          129            73           24
$17,800.....................................................           60           24            3          479          266          239           266          123            74           24
$18,100.....................................................           61           24            4          479          272          273           273          116            76           24
$18,400.....................................................           62           24            4          479          278          273           278          111            77           24
$18,700.....................................................           63           24            4          479          284          273           284          105            78           24
$19,000.....................................................           64           24            4          479          290          273           290           99            79           24
$19,300.....................................................           65           24            4          479          296          273           296           93            81           24
$19,600.....................................................           66           26            5          479          335          310           335           54            89           26
$19,900.....................................................           67           26            5          479          341          310           341           48            90           26
$20,200.....................................................           68           26            5          479          348          310           348           41            91           26
$20,500.....................................................           69           26            5          479          354          310           354           35            93           26
$20,800.....................................................           70           26            5          479          361          310           361           28            94           26
$21,100.....................................................           71           26            6          479          367          348           367           22            95           26
$21,400.....................................................           72           26            6          479          374          348           374           15            97           26
$21,700.....................................................           73           26            6          479          380          348           380            9            98           26
$22,000.....................................................           74           26            6          479          387          348           387            2           100           26
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

    This outcome is not undesirable: borrowers with higher incomes 
receive less assistance as their incomes increase, while borrowers at 
the lower end of the spectrum receive a capped amount of assistance, 
helping to ensure that the housing needs of low-income families are met 
at reasonable cost to the taxpayer and the level of assistance provided 
decreases as family income increases.
    However, the second phenomenon that occurs with certain increases 
in income is problematic: for borrowers whose payments are based on the 
floor payment, a small increase in income can lead to a large decrease 
in payment assistance. This happens because the required floor payment 
is divided into three tiers that increase at a much greater rate than 
income. For example, when a borrower's income increases from 50 percent 
of AMI to 50.01 percent, the required floor payment jumps from 22 
percent of income to 24 percent; when borrower income increases from 65 
percent of AMI to 65.01 percent, the floor payment jumps to 26 percent 
of income. Exhibit 7

[[Page 8528]]

illustrates the impact on payment assistance of a $300 increase in AAI 
that also pushes the borrower into the next tier of floor payments:

                               Exhibit 7.--Impact of Marginal Increases in Income on Payment Assistance, Current Formula*
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                        PITICost
                                                                                                          with                   Annualized
                                                                 Adjusted     AAI as a                 assistance    Payment      payment    Net Loss of
                           Example                                annual     percent of      PITI         as a      assistance   assistance     annual
                                                                  income        AMI                    percent of     amount       amount       income
                                                                                                          AAI
--------------------------------------------------------------------------------------------------------------------------------------------------------
Income.......................................................      $14,800           50         $479           22         $208       $2,496  ...........
Increase 1...................................................       15,100           51          479           24          177        2,124  ...........
Change.......................................................          300            1  ...........            2          -31         -372          $72
Income.......................................................       19,300           65          479           24           93        1,116  ...........
Increase 2...................................................       19,600           66          479           26           54          648  ...........
Change.......................................................          300            1  ...........            2          -39         -468         $168
--------------------------------------------------------------------------------------------------------------------------------------------------------
* Some figures are rounded.

    The first income increase of $300 gets offset by a loss of $372 in 
payment assistance, while the second income increase of $300 gets 
offset by a loss of $468 in payment assistance. The overall trend to 
decrease payment assistance as income increases is logical; as 
borrowers' earnings increase, they need less Government assistance. 
However, the unfortunate consequence of staggering the floor payments 
in two percent increments is that borrowers who are already at the 
lower end of the income scale can suffer a financial setback when they 
earn a pay increase; sometimes they have more to lose than gain when 
their AAI rises. A more equitable formula would leave the borrower at 
least as well off as he or she was before the pay increase.

Changing the Initial Principal Amount, Holding Other Factors Constant

    When only the principal amount varies and all other factors are 
held constant, payment assistance increases at a faster rate relative 
to increases in principal when the borrower pays based on the floor 
payment than when he or she pays based on the equivalent interest rate.
    The following exhibit illustrates this dynamic.

                              Exhibit 8.--Impact of Changes in Principal Amount on Borrower's Contribution, Current Formula
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                              Borrower's
                                                                                                                                 Borrower's   PITI  cost
                                     Payment @     Original      Floor        Floor      Payment @    Borrower's    Assistance      PITI         with
     Initial principal amount        note rate       PITI      payment of   payment of      EIR      contribution     amount      portion     assistance
                                                                  PITI          PI                       to PI                   (percent)    as percent
                                                                                                                                                of AAI
--------------------------------------------------------------------------------------------------------------------------------------------------------
$50,000...........................         $324         $414         $380         $290         $228          $290          $34           92         24.0
52,400............................          340          430          380          290          239           290           50           88         24.0
54,800............................          355          445          380          290          249           290           65           85         24.0
57,200............................          371          461          380          290          260           290           81           82         24.0
59,600............................          386          476          380          290          271           290           96           80         24.0
62,000............................          402          492          380          290          282           290          112           77         24.0
64,400............................          417          507          380          290          293           293          124           76         24.2
75,200............................          487          577          380          290          342           342          145           75         27.3
86,000............................          557          647          380          290          391           391          166           74         30.4
--------------------------------------------------------------------------------------------------------------------------------------------------------

    The exhibit shows that, given the formula inputs used in the 
sensitivity analysis, when the principal amount is between $50,000 and 
$62,000, the borrower's PITI cost with payment assistance equals 24.0 
percent. Within this range of principal amounts, the borrower's 
contribution for principal and interest is fixed at the floor payment 
of $290 per month, while payment assistance increases to make up the 
difference between the borrower's contribution and the note rate. Thus, 
the borrower has the strongest incentive to purchase the $62,000 house 
rather than a cheaper one within the 24 percent range. Once the 
principal is greater than $62,000 and the borrower pays based on the 
EIR, the borrower's contribution is no longer fixed but increases as 
principal increases. Payment assistance also increases with principal, 
but not as quickly as when the borrower pays at the floor rate.
    Thus, the current formula provides an incentive to borrowers to 
purchase the most expensive home within a fixed range of principal 
amounts'in this example, the $62,000 house. It is important to note, 
however, that the optimal purchase price has nothing to do with the 
housing market and will vary with each buyer's income, AMI, taxes and 
insurance, and the market rate on the loan--it is not uniform across 
RHS borrowers. In addition, while the inputs to the formula create an 
economically optimal purchase price for each borrower, this price is 
not necessarily the one at which a buyer will purchase a house. There 
are many other important and potentially overriding factors in the 
borrower's decision-making process, including the availability of 
appropriate housing at a price he or she can afford, the location of 
the housing, quality of the neighborhood and schools, and safety, among 
others. It is possible that a house at the buyer's optimal price is not 
available and does not meet his or her other criteria. The optimal 
price is solely based on the four inputs to the

[[Page 8529]]

payment assistance formula and does not reflect any market or quality 
factors.

Changing Tax and Insurance (T&I) Cost, Holding Other Factors Constant

    The analysis indicates that when a borrower's payment is based on 
the floor payment, the payment assistance amount matches the increase 
in T&I dollar-for-dollar. When a borrower's payment is based on EIR, 
the payment assistance amount is not affected by the change in T&I. As 
a result, very low-income borrowers must bear the burden of increased 
taxes and insurance without an increase in payment assistance, while 
low income borrowers receive a dollar-for-dollar match. This formula 
characteristic makes it difficult not only for very low-income 
borrowers to adjust to increased tax and insurance costs, but also for 
RHS to provide servicing assistance to very low-income borrowers who 
get behind in their payments as a result of a tax or insurance 
increase. Sixty-two percent of borrowers in the historic dataset pay 
based on the EIR and thus do not receive extra payment assistance when 
their T&I amount increases.

Market Research

    Included in the assessment of the payment assistance formula was a 
comparative analysis to identify other affordable housing programs 
whose features could be compared to and contrasted with the section 502 
program. None of the programs reviewed offered the same depth of 
subsidy available through the section 502 program, although many were 
similar in other respects. The single most important differentiating 
factor is the target market served by the section 502 program. The 
following programs were the primary focus of the comparative analysis:
     HUD Housing Choice Voucher Programs--Homeownership and 
Tenant Based
     Minnesota Housing Finance Agency, Minnesota Mortgage 
Program, Homeownership Assistance Fund
     HUD Home Investment Partnerships Program (HOME)
     Virginia Department of Housing and Community Development--
Share Homeless Intervention Program
     Habitat for Humanity International
     City of Longmont/Boulder County, Colorado Downpayment 
Assistance Program
     City of Livermore, California Downpayment Assistance 
Program
     Illinois Housing Development Authority, First Time 
Homebuyer Program (Revenue Mortgage Bond Program)
    Exhibit 9 shows how key features of these various programs compared 
to those of the section 502 program.

     Exhibit 9.--Program Features of the Section 502 and Comparable
                Affordable Single Family Housing Programs
------------------------------------------------------------------------
                                                    Comparative analysis
       Program feature             Section 502          observations
------------------------------------------------------------------------
Use of HUD AMI..............  HUD AMI is used as    --Eligibility
                               an eligibility        criterion.
                               criterion, for       --Assistance limits.
                               targeting purposes,  --Financing terms.
                               and as a payment     --Targeting.
                               assistance formula
                               factor.
Use of Housing Cost-PITI-to-  PITI-to-income        --Repayment ability.
 Income Ratios.                ratios are used      --Program
                               during the            eligibility.
                               underwriting         --Assistance
                               process to            eligibility.
                               determine repayment  --Participant
                               ability.              contribution.
Assistance Calculation......  Payment Assistance    --Participant need
                               is calculated by      is met up to a
                               first determining     limit.
                               the borrower's PI    --Participant need
                               contribution.         is met up to a
                               Payment Assistance    limit after a
                               covers the            required
                               difference between    participant
                               PI and this           contribution.
                               contribution.
Assistance Administration...  Continual             --Continual
                               Assistance, given     assistance.
                               that borrowers meet  --Limited
                               income and            assistance.
                               occupancy            --Limited, deceasing
                               eligibility           assistance with
                               requirements.         eventual cut-off.
                                                    --One time
                                                     assistance.
Assistance Recapture........  Entire amount of      --Entire amount.
                               payment assistance   --Pro-rated
                               is subject to         percentage.
                               recapture, given     --Recapture due
                               that it is less       within a finite
                               than the adjusted     timeframe.
                               appreciation value.
                               Payment assistance
                               is always subject
                               to recapture.
------------------------------------------------------------------------

    The most noteworthy finding of the market research was that while 
all of the homeownership and rental subsidy programs used income as a 
percentage of AMI as an eligibility criterion, none of the programs 
used the figure as a determinant of the amount of assistance received, 
as under the section 502 Program.
    Other uses of AMI in program administration include:
     Income eligibility, including income floors, to determine 
repayment capacity and program eligibility;
     Assistance limit/financing term determination; and
     Targeting specific parts of the population for assistance.

Public Forum

    On February 3, 2004, RHS hosted a forum of rural housing industry 
leaders at which it presented the findings of the sensitivity and 
historical analyses and market research, proposed preliminary 
alternatives to the current payment assistance formula, and solicited 
feedback from the participants to address inequities in the current 
formula.

Preliminary Alternatives for Calculating Payment Assistance

    RHS directed that alternatives to the current payment assistance 
formula meet the following criteria:
     Alternatives must provide service to the same target 
market currently eligible to receive assistance,
     Alternatives must be subsidy neutral, and
     Alternatives must simplify the method of determining the 
levels of payment assistance received.
    Given these criteria and the feedback from the industry forum, five 
alternatives were developed. Because of the distributional inequities 
created by

[[Page 8530]]

basing payment assistance on AMI, and the lack of precedent for using 
AMI as a determinant of payment assistance in comparable affordable 
housing programs, none of the alternatives include AMI in the formula 
for calculating payment assistance.
    The alternatives are as follows:
    Alternative 1: Calculate Monthly Payment Assistance based only on 
the borrower's AAI.
    Alternative 2: Calculate Monthly Payment Assistance based on the 
borrower's AAI (building on Alterative 1) but the borrower's 
contribution equals the greater of (a) 25 percent of AAI for PITI; and 
(b) principal and interest payment based on a one percent interest 
rate, plus taxes and insurance.
    Alternative 3: Calculate Monthly Payment Assistance as the 
difference between principal and interest at the note rate and 
principal and interest calculated at a below-market interest rate that 
is tied to the borrower's AAI.
    Alternative 4: Calculate Monthly Payment Assistance as the 
difference between PITI at the note rate and the greater of (a) 24 
percent of the borrower's AAI plus utilities and maintenance costs; and 
(b) principal and interest payment based on a one percent interest 
rate, plus taxes and insurance.
    Alternative 5: Offer an up-front principal reduction that results 
in a borrower's payment being 24 percent of AAI, with the up-front 
principal reduction amount being provided as a zero-interest loan to be 
repaid in full upon graduation from the section 502 program.
    Analyses of the five options eliminated Alternatives 1, 4, and 5. 
Alternative 4 was found to be very similar to Alternative 2, but 
difficult to explain because of the utility and maintenance cost 
component. In addition, an accurate utility and maintenance allowance 
would be difficult to establish on a nationwide basis. Alternative 1 
was eliminated because it would not serve the same target market. This 
is because alternative 1 is based only on the borrower's income, 
without regard to loan amount or taxes and insurance. Alternative 5 was 
not subsidy neutral in any year but the first.
    The contractor performed a sensitivity analysis to compare 
treatment of borrowers by the current formula, Alternative 2, and 
Alternative 3 along the same dimensions as the sensitivity analysis 
performed on the current formula. Based on borrower and loan 
characteristics for FY 2003, the sensitivity analyses were performed 
under the following assumptions:
     Borrower's AAI: $21,000
     AMI: $44,000
     Initial Principal Amount: $90,000
     Loan Term in Years: 33
     Market Rate: 7 percent
     Monthly Taxes and Insurance: $120 (1.6 percent of Initial 
Principal Amount/12 months)
    The results are as follows:
Changing AMI, Holding Other Factors Constant
    Since Alternatives 2 and 3 both eliminate AMI by design, there is 
no variability in the amount of payment assistance borrowers receive 
based on AMI under either of these alternatives. Under the current 
payment assistance formula, the amount of payment assistance varies 
with AMI.
Changing AAI, Holding Other Factors Constant
    Under the current formula and the two alternatives, there is a 
maximum payment assistance amount. The current formula and Alternative 
2 provide fairly similar amounts of payment assistance while 
Alternative 3 provides a greater amount of payment assistance to almost 
all borrowers whose incomes are above the cap.
    Exhibit 10 shows this effect.

Exhibit 10.--Impact of Changes in Income on Payment Assistance, Current 
Formula and Alternatives

BILLING CODE 3410-XV-P

[[Page 8531]]

[GRAPHIC] [TIFF OMITTED] TP17FE06.000

    Assumptions for Exhibit 10:
    (1) Loan amount = $90,000
    (2) T&I = 1.6 percent of loan amount
    (3) Note rate = 7 percent
    (4) AMI = $44,000

[[Page 8532]]

    Under the current formula, the cap is determined by the ratio of 
AAI to AMI. When the ratio increases, the amount of payment assistance 
drops by more than the increase in income. This effect does not occur 
under either Alternative 2 or Alternative 3. The table below shows a 
borrower's monthly payments when income equals $21,000, $22,000, and 
$23,000, with tax and insurance payments ranging from 0.5 percent to 
3.5 percent of the loan. Borrower payments that are not bolded are 
based on 25 percent of income. In this example, the borrower pays 25 
percent when T&I is relatively low. The borrower payments that are 
bolded are based on a one percent interest rate.

                            Exhibit 11.--Impact of Change in Income on Borrower Payment and Payment Assistance, Alternative 2
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                Income = $21,000          Income = $22,000          Income = $23,000
                                                T&I as                     -----------------------------------------------------------------------------
                   Number                     percent of    T&I      PITI     Borrower                  Borrower                  Borrower
                                                 loan                       payment for    Payment    payment for    Payment    payment for     Payment
                                                                                PITI      assistance      PITI      assistance      PITI      assistance
--------------------------------------------------------------------------------------------------------------------------------------------------------
1..........................................         0.50      $38     $621         $438         $183         $458         $162         $479         $142
2..........................................         0.70       53      636          438          198          458          177          479          157
3..........................................         0.90       68      651          438          213          458          192          479          172
4..........................................         1.10       83      666          438          228          458          207          479          187
5..........................................         1.30       98      681          438          243          458          222          479          202
6..........................................         1.50      113      696          438          258          458          237          479          217
7..........................................         1.70      128      711          438          273          458          252          479          232
8..........................................         1.90      143      726          438          288          458          267          479          247
9..........................................         2.10      158      741          438          303          458          282          479          262
10.........................................         2.30      173      756          439          316          458          297          479          277
11.........................................         2.50      188      771          454          316          458          312          479          292
12.........................................         2.70      203      786          469          316          469          316          479          307
13.........................................         2.90      218      801          484          316          484          316          484          316
14.........................................         3.10      233      816          499          316          499          316          499          316
15.........................................         3.30      248      831          514          316          514          316          514          316
16.........................................         3.50      263      846          529          316          529          316          529          316
--------------------------------------------------------------------------------------------------------------------------------------------------------

    Thus, when the borrower's payment is based on 25 percent of income, 
and the borrower's annual income goes from $21,000 to $22,000, the 
monthly payments increase by $20, for an annual increase of $240 and a 
net gain in income of $760. When the borrower's payment is based on the 
one percent interest rate, the amount of the payment does not change. 
Similarly, when the borrower's payment is based on 25 percent of income 
and income goes from $21,000 to $23,000, the monthly payment increases 
by $40, for an annual increase of $480 and a net gain in income of 
$1,520. When the borrower's payment is based on the one percent rate, 
his or her payment does not change.
    Under Alternative 3, the EIR scale increases so gradually relative 
to increases in income that the borrower will not face a situation in 
which a loss in payment assistance exceeds an increase in earnings. 
Exhibit 12 shows how borrower payments increase with income, assuming 
the loan and borrower characteristics described at the beginning of 
this section. The payments do not change with taxes and interest, 
unlike under Alternative 2.

        Exhibit 12.--Impact of Change in Income on Borrower Payment and Payment Assistance, Alternative 3
----------------------------------------------------------------------------------------------------------------
                                                                     Borrower
                             Income                                 payment for       Payment          PITI
                                                                       PITI         assistance
----------------------------------------------------------------------------------------------------------------
$21,000.........................................................            $408            $295            $703
$22,000.........................................................             419             284             703
$23,000.........................................................             431             273             703
----------------------------------------------------------------------------------------------------------------

    As Exhibit 12 shows, a borrower who earns $21,000 and receives a 
$1,000 raise must pay an additional $11 per month for housing, or $132 
per year. If the borrower who earns $21,000 receives a $2,000 pay 
raise, the payment increases by $23 per month, or $276 per year.
Changing the Initial Principal Amount, Holding Other Factors Constant
    Under the current formula the borrower has an incentive to purchase 
a house at the upper end of a certain price range. The same phenomenon 
occurs under Alternative 2, as shown in Exhibit 14 below.

             Exhibit 14.--Impact of Changes in Principal on Borrower Payment and Payment Assistance
----------------------------------------------------------------------------------------------------------------
                                                                                          Borrower
                           Number                              Principal       T&I        payment      Payment
                                                                                            PITI      assistance
----------------------------------------------------------------------------------------------------------------
1...........................................................      $40,000          $53         $313           $0
2...........................................................       50,000           67          391            0
3...........................................................       60,000           80          438           31
4...........................................................       70,000           93          438          110

[[Page 8533]]

 
5...........................................................       80,000          107          438          188
6...........................................................       90,000          120          438          266
7...........................................................      100,000          133          438          344
8...........................................................      110,000          147          473          387
9...........................................................      120,000          160          516          422
10..........................................................      130,000          173          559          457
----------------------------------------------------------------------------------------------------------------

    As Exhibit 14 shows, the borrower's payment is the same when the 
principal ranges between $40,000 and $90,000, so the borrower has an 
incentive to purchase the $90,000 house.
    Under Alternative 3, however, this effect does not occur because 
both the borrower's payment and the payment assistance increase with 
the principal amount. The following exhibit illustrates this dynamic.

   Exhibit 15.--Impact of Change in Principal on Borrower Payment and
                    Payment Assistance, Alternative 3
------------------------------------------------------------------------
                                                  Borrower
            Principal              T&I at 1.6%  payment for    Payment
                                                    PITI      assistance
------------------------------------------------------------------------
$40,000..........................          $53         $181         $131
$50,000..........................           67          227          164
$60,000..........................           80          272          197
$70,000..........................           93          318          229
$80,000..........................          107          363          262
$90,000..........................          120          408          295
$100,000.........................          133          454          328
$110,000.........................          147          499          361
$120,000.........................          160          544          393
$130,000.........................          173          590          426
------------------------------------------------------------------------

    In addition, under the current formula and Alternative 2, borrowers 
with higher loan amounts receive more payment assistance than under 
Alternative 3, while borrowers with lower initial principal amounts 
receive more payment assistance under Alternative 3 than under either 
the current formula or Alternative 2. Exhibit 16 shows this effect.

Exhibit 16.--Impact of Changes in Principal on Payment Assistance, 
Current Formula and Alternatives

[[Page 8534]]

[GRAPHIC] [TIFF OMITTED] TP17FE06.001

    Assumptions for Exhibit 16:
    (1) AAI = $21,000
    (2) T&I = 1.6% of loan amount
    (3) Note rate = 7%
    (4)AMI = $44,000

[[Page 8535]]

Changing Tax and Insurance Cost, Holding Other Factors Constant
    Under the current formula and Alternative 2, payment assistance 
sometimes covers increases in taxes and insurance. Under the current 
formula, when the borrower pays at the EIR, payment assistance does not 
change with changes in taxes and insurance, but when the borrower pays 
the floor payment, payment assistance increases to cover increases in 
taxes and insurance. Thus, borrowers whose incomes are very low 
relative to their AMI receive a capped amount of payment assistance.
    Under Alternative 2, payment assistance increases relative to 
increases in taxes and insurance as long as the borrower is paying 25 
percent of income. Borrowers pay 25 percent of income when their income 
is high relative to their PITI. When the borrower's payment equals one 
percent plus T&I, the payment assistance amount is capped, which means 
that as taxes rise, payment assistance does not. This means borrowers 
in high tax areas receive proportionately less payment assistance 
relative to their payment than borrowers in low tax areas, all other 
factors being equal.
    Under Alternative 3, payment assistance is the same regardless of 
T&I amount. Thus, borrowers with the same principal but different tax 
and insurance rates receive the same amount of payment assistance.
    Exhibit 17 below illustrates this dynamic:

Exhibit 17.--Impact of Changes in Taxes and Insurance on Payment 
Assistance, Current Formula and Alternatives

[[Page 8536]]

[GRAPHIC] [TIFF OMITTED] TP17FE06.002

    Assumptions for Exhibit 17:
    (1) AAI = $21,000
    (2) Loan amount = $90,000
    (3) Note rate = 7%
    (4) AMI = $44,000

[[Page 8537]]

Impact of the Alternatives on the Current Market
    In addition to these analyses, the contractor also studied the 
question of how both alternatives would impact the market that the 
current formula serves. To assess whether each alternative formula will 
serve the same target market, three states were selected to represent 
high, medium, and low cost states. Average borrowers' AAI, Initial 
Principal Amount, and T&I were calculated for the counties that had at 
least 10 new borrowers in 2002 and 2003. The counties with the highest 
average borrower's AAI were selected to represent the high-income 
borrower's profile in each state. The same methodology applies to both 
median and low-income borrower profiles in each state. The contractor 
assessed how much payment assistance borrowers with low, median, and 
high incomes would receive, as well as the proportion of their income 
that would go toward housing under each alternative.
    Under the current formula and Alternative 2, borrowers receive 
similar payment assistance and pay a similar percentage of their income 
to housing. Under Alternative 3, borrowers with high incomes in 
California and Illinois receive significantly less payment assistance 
than under the current formula, and many of them would also pay more 
than 29 percent of their income toward housing, thus disqualifying them 
from receiving a section 502 loan.
    Exhibits 18 and 19 below illustrate these results:

Exhibit 18.--Payment Assistance Amounts in High-, Medium-, and Low-Cost 
States, Current Formula and Alternatives

[[Page 8538]]

[GRAPHIC] [TIFF OMITTED] TP17FE06.003


[[Page 8539]]



Exhibit 19.--Adjusted PITI-to-Income Ratios in High-, Medium-, and Low-
Cost States, Current Formula and Alternatives
[GRAPHIC] [TIFF OMITTED] TP17FE06.004

BILLING CODE 3410-XV-C

[[Page 8540]]

    In addition, applying the three formulas to the new borrowers in FY 
2003 \3\, the analysis showed that the average ratio of borrower PITI 
with assistance to income was nearly identical for each formula, with 
Alternative 3 the lowest (26.7 percent) and the current formula the 
highest (27.4 percent).\4\ The ratio of payment assistance to total 
payment for principal, interest, taxes, and insurance was also fairly 
uniform across the three alternatives, with Alternative 3 the lowest at 
(38.3 percent) and the current formula the highest at 39.8 percent.\5\ 
More noteworthy was the number of current borrowers each formula would 
exclude from the program. Applying the requirements of each formula to 
the new borrowers in FY 2003, it was found that under Alternative 3 a 
sizeable number would have payments that exceed the maximum payment to 
income ratio of 29 percent for very low-income borrowers and 33 percent 
for low-income borrowers.
---------------------------------------------------------------------------

    \3\ New Non-Leveraged Loan borrowers who have loan origination 
dates within fiscal year 2003 (10/1/02 to 9/30/03) and have the 
first payment assistance agreement records in the provided dataset.
    \4\ Average borrowers' adjusted PITI-to-Income ratio was 
calculated using a simple average.
    \5\ Average ratio of payment assistance to PITI was calculated 
using a weighted average of original loan amounts.

                                                   Exhibit 19
----------------------------------------------------------------------------------------------------------------
                                                   Average
                                      Average      PITI to
                                      adjusted      income     Number of    Percent of   Number of    Percent of
             Scenario                 PITI to    (exclude 17   borrowers      total      borrowers      total
                                       income     outliers)*      >29%                      >33%
                                     (percent)    (percent)
----------------------------------------------------------------------------------------------------------------
Current Formula...................        28.19        27.43        1,744           29          706        11.86
Alternative 2.....................        28.29        27.53        1,319           22          571         9.59
Alternative 3.....................        27.47        26.70        1,764           30          854       14.34
----------------------------------------------------------------------------------------------------------------
* Notes: 1. Exclude the 17 outliers with the percentage exceeding 100%.
2. Based on 5,954 new non-leveraged loan borrowers' information in fiscal year 2003.

Revision of the Payment Assistance Calculation

    RHS proposes to revise the payment assistance formula by 
implementing Alternative 2. Payment assistance will be calculated by 
taking the difference between the total cost of PITI minus the 
borrower's contribution, which will be the higher of 25 percent of AAI 
or P&I calculated at a 1 percent interest rate plus the cost of taxes 
and insurance.

Formula

Payment Assistance = PITI-Borrower's PITI Contribution

    Borrower's contribution is the higher of the following 
calculations:
     25% of AAI
     P&I calculated at 1% Interest Rate + T&I
    Alternative 2 improves upon the current formula in that it is a 
more simplified approach and is easier to explain to borrowers and 
others interested in the program. Alternative 2 does not rely on AMI, 
which was the main factor in unintended consequences of the current 
formula. In addition, Alternative 2 provides for consideration of 
property taxes and insurance cost which is very important in some 
segments of the RHS market. Under alternative 2, borrowers may be 
encouraged to buy the most expensive home possible in order to get the 
maximum amount of payment assistance. This is similar to the current 
formula. The Agency believes that this issue is mitigated by loan 
underwriting criteria, such as repayment ratios and Area Loan Limits. 
Borrowers in high tax areas will receive proportionately less payment 
assistance than borrowers in low tax areas. This is also similar to the 
current formula.
    Alternative 3, on the other hand, provides more generous payment 
assistance to higher income borrowers in many cases, is a more complex 
formula requiring periodic adjustments, and would exclude more 
borrowers with PITI costs in excess of 33% of income than would 
Alternative 2 or the current formula.
    The impact of implementation of Alternative 2 is the removal of AMI 
as part of the calculation. This will result in a more consistent and 
fair distribution of subsidy, especially in neighboring counties.

Leveraged Loans

    Leveraged loans, under the current regulation, are not subject to 
the floor rate portion of the payment assistance formula. Payment 
assistance for a leveraged loan is determined using only the EIR. This 
provision has influenced the payment assistance calculation as well as 
the amount of funds available for borrowers in rural areas. To assess 
the impact of leveraged loans, RHS included a review of the leveraging 
policy in its overall assessment of the payment assistance formula.
    In the mid-1990s, RHS adopted a policy of encouraging borrowers to 
obtain a portion of their financing from commercial lenders. The 
rationale behind this policy was, in part, to increase the amount of 
funds available for rural borrowers by utilizing private lenders to 
supply a portion of the financing. For example, if RHS has authority to 
lend $1 billion for section 502 direct loans and borrowers collectively 
secure 20 percent of their financing from private lenders, then RHS has 
effectively increased its available funding to $1.2 billion and is able 
to assist 2,500 more families than otherwise would have been possible 
(assuming an average principal amount of $80,000). However, the results 
of the payment assistance assessment demonstrate that the actual effect 
of leveraging decreases the amount of funds available.

Effects of Leveraging Policy on Program Level

    The following exhibits demonstrate the effects of the current 
leveraging policy on the amount of funds available to finance housing 
in rural areas. The Payment Assistance to Principal and Interest 
payment at the note rate (PA/PI Ratio) represents the most significant 
factor that determines the subsidy rate for the program. For the 
purposes of this illustration, it is assumed that the other four inputs 
to calculate subsidy rate remain constant. Thus, the same percentage 
change in the PA/PI ratio will be carried over to the subsidy rate. 
Further, to demonstrate the effects, it is necessary to assume the 
level of budget authority remains the same.
    Definitions:

[[Page 8541]]

     Program level is the amount of financing available to 
finance single family homes.
     Budget Authority is the actual cost of providing the 
financing.
     Subsidy Rate is the factor used to determine budget 
authority. It includes interest subsidy, a factor of loan losses, 
maintenance, and other costs associated directly with the loan.
    The program level is determined by dividing available budget 
authority by the subsidy rate. For example, under the current formula, 
$201 million in budget authority divided by .194 subsidy rate (the 
program subsidy rate for FY 2003) equals $1,038 million in program 
level. There is only one subsidy rate for the entire section 502 direct 
loan program, which includes both leveraged, and non-leveraged loans. 
The following rates are for illustrative purposes to show the 
difference in cost for the leveraging provision of the payment 
assistance formula (i.e. leveraged loans under the current formula are 
not subject to the payment assistance floor rate.)

Exhibit 20.

                                 Current Formula Including Leveraging Provision
----------------------------------------------------------------------------------------------------------------
                 Program level                          Budget authority           Subsidy rate     PA/PI ratio
----------------------------------------------------------------------------------------------------------------
$1,038 million................................  $201 million....................          19.40%           39.75
----------------------------------------------------------------------------------------------------------------


                                   Alternative 2 Without Leveraging Provision
----------------------------------------------------------------------------------------------------------------
                                                                                     Estimated
                 Program level                          Budget authority           subsidy rate     PA/PI ratio
----------------------------------------------------------------------------------------------------------------
$1,100 million................................  $201 million....................          18.27%           37.43
----------------------------------------------------------------------------------------------------------------


                                  Alternative 2 With 30% Leveraging Requirement
----------------------------------------------------------------------------------------------------------------
                                                                                     Estimated
                 Program level                          Budget authority           subsidy rate     PA/PI ratio
----------------------------------------------------------------------------------------------------------------
$838 million..................................  $201 million....................          23.99%           49.16
----------------------------------------------------------------------------------------------------------------

    Comparing the first two formulas, the 5.8 percent decrease in the 
PA/PI ratio occurs with the elimination of the leveraging provision. 
Applying the same percentage decrease to the subsidy rate and dividing 
the budget authority by that result produces a $62 million (or 6 
percent) increase in the program level.
    Conversely, with the inclusion of a requirement of obtaining 30 
percent of each loan from commercial lenders, the PA/PI ratio increases 
by 24 percent. Applying the same percentage increase to the subsidy 
rate raises it to 23.99 percent, which causes the program level to 
decrease 19 percent to $838 million.
    Of the 219,281 payment assistance agreements analyzed as part of 
this assessment, 66,451 (30 percent) were for leveraged loans, meaning 
that a portion of the original principal amount was obtained from a 
private lender.\6\
---------------------------------------------------------------------------

    \6\ Included in the definition of leveraged loans are situations 
in which non-profit organizations provide a grant to buy down the 
original principal amount.
---------------------------------------------------------------------------

    Even though 30 percent of the 219,281 payment assistance agreements 
made between 1996 and 2003 were associated with leveraged loans, the 
leveraged portion of the amount of principal financed by borrowers was 
relatively insignificant. Of the 10,502 new borrowers in fiscal year 
2003, 4,548 (43 percent) were leveraged loans, but the leveraged 
portion of the principal accounted for only 8.16 percent of the total 
loan level.\7\ The effect of leveraging at different thresholds (e.g., 
30 percent and 40 percent), on the total loan volume is demonstrated in 
the following exhibits:
---------------------------------------------------------------------------

    \7\ The assessment was performed on the borrowers who have a 
loan origination date within fiscal year 2003 and have the first 
payment assistance agreement in the provided dataset.

                                      Exhibit 21.--Details of Fiscal Year 2003 New Borrowers' Leverage Information
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                             Number of                                                        Leveraged
                                                                 PA/P&I @       non       Number of                $ Leveraged    $ Total    loans/total
                       Current formula                          note rate    leveraged    leveraged   Total loans  loan amount  loan amount     amount
                                                                  year 1       loans        loans                                             (percent)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Actual Payment Assistance....................................       39.75%        5,954        4,548       10,502      $77.4 M       $948 M         8.16
--------------------------------------------------------------------------------------------------------------------------------------------------------


                               Payment Assistance Ratio of Alternative 2 in Year 1
----------------------------------------------------------------------------------------------------------------
                                        PA/P&I @
                      Provision &      note rate    Leveraged              $ Leveraged    $ Total    $ Leveraged/
    Scenario           threshold       in year 1      loans       Total       amount    loan amount    $ total
                                       (percent)                                                      (percent)
----------------------------------------------------------------------------------------------------------------
1...............  Without Leverage..        37.43            0     10,502        $0.00  $948,343.39         0.00
2...............  With Provision 30%        49.16        3,850     10,502    96,999.33   948,343.39        10.23
                   Threshold.
3...............  With Provision 20%        19.15        4,646     10,502    79,169.39   948,343.39         8.35
                   Threshold.
----------------------------------------------------------------------------------------------------------------



[[Page 8542]]

    Note: In evaluating the effects of requiring borrowers to obtain 
30 percent of the principal from commercial lenders, it was apparent 
that leveraging would benefit only 3,850 of the 10,502 borrowers, 
and the remainder would obtain a non-leveraged loan. Some elect to 
pay 25 percent of AAI toward PITI, and some are paying at 1 percent 
interest rate under a non-leveraged scenario. The equivalent amount 
of leveraged principal for the 3,850 borrowers is $97 million, 
equaling 10.23 percent of the total lending. The same logic would 
hold true if the leveraging threshold was set at 20 percent.


    Because leveraging did not appear to be achieving the policy 
objective of increasing the funding available for rural homeowners, the 
assessment also analyzed the results of raising the leveraging 
threshold to minimum levels of 20 percent and 30 percent. Not only did 
establishing a minimum level not materially affect the total amount of 
funding available, 8.35 percent and 10.23 percent respectively, the 
minimum levels significantly increased the amount of payment assistance 
required.
    Hence, the policy of using the payment assistance formula to 
encourage leveraging actually decreases available funding. The effect, 
with two different market interest rates, is demonstrated in the 
following exhibits:
Assumptions
    (1) AAI = $24,000
    (2) Note Rate = Market Rate
    (3) Annual T&I = 1.8 percent of principal

                                                       Exhibit 22.--Market Interest Rate 6 Percent
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                  Adjusted     Weighted
                                                                  Total                                 PA ratio                  PITI-to-     average
                 No.                          Scenario           original    USDA loan        PA        (PA/USDA    Borrower's     income      interest
                                                                  amount       amount                     P&I)      total P&I      ratio         rate
                                                                                                       (percent)                 (percent)    (percent)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1...................................  Non-Leveraged..........      $90,000      $90,000         $142          $27         $380        25.00  ...........
2...................................  Leveraged (20%)........       90,000       72,000          204           49          318        21.90          2.0
3...................................  Leveraged (30%)........       90,000       63,000          179           49          344        23.18          2.5
--------------------------------------------------------------------------------------------------------------------------------------------------------


                                                       Exhibit 23.--Market Interest Rate 8 Percent
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                  Adjusted     Weighted
                                                                  Total                                 PA ratio                  PITI-to-     average
                 No.                          Scenario           original    USDA loan        PA        (PA/USDA    Borrower's     income      interest
                                                                  amount       amount                     P&I       total P&I      ratio         rate
                                                                                                       (percent)                 (percent)    (percent)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1...................................  Non-Leveraged..........      $90,000      $90,000         $267           41         $380        25.00  ...........
2...................................  Leveraged (20%)........       90,000       72,000          304           59          343        23.14         2.40
3...................................  Leveraged (30%)........       90,000       63,000          266           59          381        25.04         3.10
--------------------------------------------------------------------------------------------------------------------------------------------------------

    Based on the results demonstrated by this analysis, RHS proposes 
not to provide additional payment assistance or use the payment 
assistance formula as a means of encouraging the use of leveraged 
funding. It is simpler to have a single calculation. So, in conclusion, 
RHS proposes to adopt Alternative 2, under which payment assistance 
will be based on a borrower contribution of 25% of AAI towards PITI, 
however in no case will the amount of payment assistance exceed the 
amount needed to repay the loan if it were amortized at a one percent 
rate.

List of Subjects in 7 CFR Part 3550

    Accounting, Housing, Loan programs--Housing and community 
development, Low and Moderate income housing, Manufactured homes, 
Reporting and recordkeeping requirements, Rural areas, Subsidies.
    Therefore, Chapter XXXV, title 7, Code of Federal Regulations is 
proposed to be amended to read as follows:

PART 3550--DIRECT SINGLE FAMILY HOUSING LOANS AND GRANTS

    1. The authority citation for part 3550 continues to read as 
follows:

    Authority: 5 U.S.C. 301; 42 U.S.C. 1480.

Subpart B--Section 502 Origination

    2. Section 3550.68 is revised to read as follows:


Sec.  3550.68  Payment subsidies.

    RHS administers three types of payment subsidies: interest credit, 
payment assistance method 1, and payment assistance method 2. Payment 
subsidies are subject to recapture when the borrower transfers title or 
ceases to occupy the property.
    (a) Eligibility for payment subsidy. (1) Applicants or borrowers 
who receive loans on program terms are eligible to receive payment 
subsidy if they personally occupy the property and have adjusted income 
at or below the applicable moderate-income limit.
    (2) Borrowers with loans approved before August 1, 1968, are not 
eligible for payment assistance, even if they assumed the loan after 
that date.
    (3) Payment subsidy may be granted for initial loans or subsequent 
loans made in conjunction with an assumption only if the term of the 
loan is at least 25 years or more.
    (4) Payment subsidy may be granted for subsequent loans not made in 
conjunction with an assumption if the initial loan was for a term of 25 
years or more.
    (b) Determining type of payment subsidy. (1) A borrower currently 
receiving interest credit will continue to receive it for the initial 
loan and for any subsequent loan for as long as the borrower is 
eligible for and remains on interest credit.
    (2) A borrower currently receiving payment assistance using payment 
assistance method 1 will continue to receive it for the initial loan 
and for any subsequent loan for as long as the borrower is eligible for 
and remains on payment assistance method 1.
    (3) A borrower who has never received payment subsidy, or who has 
stopped receiving interest credit or payment assistance method 1, and 
at a later date again qualifies for a payment subsidy, will receive 
payment assistance method 2.
    (c) Calculation of payment assistance. Regardless of the method 
used, payment assistance may not exceed the amount necessary if the 
loan were amortized at an interest rate of one percent.
    (1) Payment assistance method 2. The amount of payment assistance 
granted is the lesser of the difference between:

[[Page 8543]]

    (i) The annualized promissory note installment plus the cost of 
taxes and insurance less twenty-five percent of the borrower's adjusted 
income; or
    (ii) The annualized promissory note installment less amount the 
borrower would pay if the loan were amortized at an interest rate of 
one percent.
    (2) Payment assistance method 1. The amount of payment assistance 
granted is the difference between the annualized note rate installment 
as prescribed on the promissory note and the lesser of:
    (i) The floor payment, which is defined as a minimum percentage of 
adjusted income that the borrower must pay for PITI: 22 percent for 
very low-income borrowers, 24 percent for low-income borrowers with 
adjusted income below 65 percent of area adjusted median, and 26 
percent for low-income borrowers with adjusted incomes between 65 and 
80 percent of area adjusted median; or
    (ii) The annualized note rate installment and the payment at the 
equivalent interest rate, which is determined by a comparison of the 
borrower's adjusted income to the adjusted median income for the area 
in which the security property is located. The following chart is used 
to determine the equivalent interest rate.
Percentage of Median Income and the Equivalent Interest Rate
    When the applicant's adjusted income is:

------------------------------------------------------------------------
                                                             THEN the
                                                            equivalent
 Equal to or more than: (percent)      BUT less than:      interest rate
                                                              is \1\
                                                             (percent)
------------------------------------------------------------------------
00................................  50.01 of adjusted                  1
                                     median income.
50.01.............................  55 of adjusted                     2
                                     median income.
55................................  60 of adjusted                     3
                                     median income.
60................................  65 of adjusted                     4
                                     median income.
65................................  70 of adjusted                     5
                                     median income.
70................................  75 of adjusted                     6
                                     median income.
75................................  80.01 of adjusted                6.5
                                     median income.
80.01.............................  90 of adjusted                   7.5
                                     median income.
90................................  100 of adjusted                  8.5
                                     median income.
100...............................  110 of adjusted                    9
                                     median income.
110...............................  Or more than                    9.5
                                     adjusted median
                                     income.
------------------------------------------------------------------------
\1\ Or note rate, whichever is less; in no case will the equivalent
  interest rate be less than one percent.

    (d) Calculation of interest credit. The amount of interest credit 
granted is the difference between the note rate installment as 
prescribed on the promissory note and the greater of:
    (1) Twenty percent of the borrower's adjusted income less the cost 
of real estate taxes and insurance, or
    (2) The amount the borrower would pay if the loan were amortized at 
an interest rate of one percent.
    (e) Annual review. The borrower's income will be reviewed annually 
to determine whether the borrower is eligible for continued payment 
subsidy. The borrower must notify RHS whenever an adult member of the 
household changes or obtains employment, there is a change in household 
composition, or if income increases by at least 10 percent so that RHS 
can determine whether a review of the borrower's circumstances is 
required.

    Dated: February 3, 2006.
Thomas C. Dorr,
Under Secretary, Rural Development.
[FR Doc. 06-1349 Filed 2-16-06; 8:45 am]
BILLING CODE 3410-XV-P