Mortgage Defects Are Growing In Prominence

The share of mortgage with critical defects rose for the second straight quarter as more borrowers tapped home equity through cash-out refinances. That’s according to ACES Quality Management‘s QC Industry Trends Report for the second quarter of 2025.

The report, which was released Tuesday and analyzes post-closing quality control data derived from the company’s software, found that the overall critical defect rate increased from 1.31% in Q1 2025 to 1.51% in the second quarter.

The report noted that higher defect findings in collateral drove the increase, which was primarily driven by eligibility and regulatory-related categories.

“Although the overall critical defect rate increased for a second straight quarter, the situation is nuanced,” said Nick Volpe, executive vice president at ACES Quality Management. “The rise was mainly in specific categories such as appraisals and eligibility-related areas.

“Meanwhile, other key underwriting areas saw notable improvements. This mixed performance demonstrates the importance of continuous monitoring and targeted quality control efforts.”

Income and employment documentation remained the largest sources of critical defects, but they improved significantly, dropping compared to the previous quarter from 22.99% to 18.45% of all critical defects. Credit and liabilities defects also declined sharply.

Assets represented the only underwriting category to increase, rising from 11.49% to 12.92% of all critical defects.

Sub-category analysis shows increased defects found in calculation/analysis
(up from 20% to 25.71%) and eligibility (up from 0% to 5.71%). Documentation defects declined (from 80% to 68.57%), indicating that analytical and eligibility checks remain as areas for focus.

Outside of underwriting, however, lenders saw a spike in collateral-related problems. Appraisal defects surged from 2.3% to 5.9% of all critical findings. Borrower and mortgage eligibility defects increased from 6.90% to 15.87%, and property-eligibility issues rose to 4.06% after none were reported in the first quarter.

Purchase defect share decreased to 73.96%, while refinance defect share climbed to 26.04% amid increased cash-out activity.

By loan type, the conventional defect share decreased to 59.62%. The Federal Housing Administration (FHA) loan share increased to 30.22%, the U.S. Department of Veterans Affairs (VA) loan share increased to 9.62%, and the U.S. Department of Agriculture (USDA) loan share decreased to 0.55%.

“Mortgage market activity increased modestly during the quarter but remained well
below pandemic-era peaks,” the report explained. “Total loan originations rose 19.4% quarter over quarter, a gain attributed more to seasonal momentum and short-lived rate dips than to any broad-based housing recovery.

“Refinance lending accounted for most of the increase, up roughly 27% from Q1, as some homeowners took advantage of marginal rate improvements to reset loan terms or access home equity.”

Refinance loans accounted for 17.33% of the reviewed files, up from 12.4% in Q1 2025, while the refinance defect share increased from 19.57% to 26.04.