Income Eligibility Defects Drive Mortgage Quality Decline

Loan quality risks amid ongoing mortgage market challenges are continuing to emerge, according to the newest QC Industry Trends Report from ACES Quality Management, which tracks post-closing quality control data from its platform.

The overall critical defect rate in the first quarter of 2025 climbed to 1.31%, ending two straight quarters of improvement and up from the historic low of 1.16% in Q4 2024. While the report, released Wednesday, said this isn’t a cause for alarm, it does signal a slight dip in loan quality following several quarters of steady gains.

“There’s no one issue that contributed to defects,” Nick Volpe, executive vice president of ACES Quality Management, said in an interview with HousingWire. “We got a little bit of a rate blip in the fourth quarter. They went back up in January. And it wasn’t a refi boom that happened in the fourth quarter by any stretch of the imagination, but after such a prolonged period of elevated rates, any little bit helps.

“The rates did change a little bit in the first quarter. Historically, what we’ve seen is when rates do tick up from quarter to quarter, you get sort of a mad rush to get things closed, avoid rate locks expiring,” he added. “They may have locked in a rate in December but the actual loan didn’t close in the first quarter. And you get some more internal pressure to get things done; you have to move faster there.”

‘Little wiggle room’

Of the numerous categories covered in the report, income and employment defects jumped by nearly half, reclaiming the top spot at 23% of all critical defects.

Borrower and mortgage eligibility defects spiked by 328% quarter over quarter, while credit defects rose 12%. Volpe said that the first increase is so dramatic because the figure was so low in the fourth quarter of 2024.

“It also shows lenders are stretching to fit borrowers into programs. With affordability tight and little wiggle room on guidelines, even small miscalculations can create defects. It’s less a mortgage-specific issue than a reflection of the broader economy,” he said.

Some categories, however, showed improvement.

Asset-related defects fell from 16.1% of all defects in Q4 2024 to 11.5% in Q1 2025. Legal, regulatory and compliance issues declined from 22.6% to 14.9% during the same period. Appraisal defects fell even more sharply, down 52.5%, while insurance defects edged up slightly to represent 3.45% of all defects

“We just see wild vacillations in those categories where one quarter it’s really good, and then the next quarter, it just balloons for really no reason. You can’t go back and point to there was a major regulatory change that took effect during the quarter that could have driven it,” Volpe said.

“I would say, overall, lenders have gotten better on that regulatory compliance category over the last three or four years.”

Volpe added that the wavering doesn’t indicate any strong compliance issues.

“When we tend to see issues in those categories, it’s around sloppiness. It’s just people running too fast and a document doesn’t get into a file. They don’t have the borrower sign on in the right place, or sign at all. And so we see a bunch of one-off issues, but not a whole lot of reverting to having compliance problems in these individual files.”

He said that he’s keeping a close eye on the asset and credit defect categories.

“The average borrower today is stressed, so assets is a great place to keep an eye on. I think credit is going to be another one going forward, especially with the rise in buy now, pay later (programs).”

Proactive QC matters

On the loan purpose side, the refinance defect share rose 13.8% despite a 9.4% decline in review volume. And the purchase loan defect share fell 2.9% even as review volume increased 1.5%.

By product type, conventional loans continued to dominate both the review and defect shares, with the defect share rising slightly to 65.9%. Federal Housing Administration loan defects held steady at 25.5%. U.S. Department of Veterans Affairs loans saw their share of defects rise modestly to 7.45%. And U.S. Department of Agriculture loans showed significant improvement, with the defect share falling from 3.23% to 1.06% despite a higher review volume.

“The rise in critical defects this quarter underscores how market volatility and operational pressure can impact loan quality,” Volpe said. “At the same time, lenders that invest in automation and proactive quality control are showing measurable improvements, particularly in underwriting and compliance.”

The report also included an economic discussion on variables that may have impacted defects. These include steep tariffs and policy swings, which created broad volatility across the bond markets. Elevated rates played a role too, according to Volpe.

He believes the appraisal and insurance categories will shift in the next quarter based on his own observations.

“I know the report is only through Q1 2025 and we’re now in August, but you know, over the summer, where most people would predict it to be just a fantastic buying season, you see the reports every day that some of the big markets — Florida, Texas and Colorado — there’s just a lot of softening there, and we’re just not seeing it in the appraisal numbers,” Volpe said.

“Couple that with parts of the country that are still dealing with last year’s hurricane season. The inability to get insurance in some of those places and the redrawing of flood maps … we have not seen those play out in the defects. And, you know, knock on wood, maybe they won’t, but I just still have a weird feeling that there’s going to be a shoe that drops on those categories.”