Insuring Federal Housing Authority Mortgages
You may have heard of private mortgage insurance (PMI), an insurance you have to pay for when you take out a home loan with a down payment of less than 20% from a conventional lender. Unfortunately, while the Federal Housing Authority (FHA) is more generous than conventional lenders in many respects, it, too, requires mortgage insurance for low down payment loans. In this article, you'll learn what FHA mortgage insurance is, how it differs from PMI, who is required to carry it and for how long, how much it costs, and your options for avoiding it or getting rid of it. Let's get started.
TUTORIAL: Mortgage Basics
What Is FHA Mortgage Insurance?
Like PMI, the purpose of FHA mortgage insurance is to protect the lender. When borrowers have minimal equity in their homes, the risk (to the lender) that the borrower will default is higher, because the borrower doesn't have as much to lose by walking away and letting the bank foreclose on the home (just look at all the people who walked away from their 0%-down-payment, housing-bubble mortgages). (To learn more about the FHA, be sure to read Understanding FHA Home Loans.)
FHA loans have lower down payment requirements, and less stringent income and credit requirements than conventional loans. However, if you were lending a large amount of money to someone, with less-than-perfect borrowing characteristics, you'd want a guarantee that you'd get repaid one way or another, too. With mortgage insurance, if you stop making your mortgage payments and walk away from your home, the insurer will help your lender recoup its losses. So, while mortgage insurance may seem like a nuisance because it doesn't protect the purchaser, if it didn't exist, many people would probably not be able to get loans at all until they had higher down payments, because the banks would view the loans as too risky. Many people find paying mortgage insurance premiums a better option than waiting several years until they have a high enough down payment to avoid it. (Is using a second mortgage the best option to avoid PMI? Read Outsmart Private Mortgage Insurance to learn more.)
The FHA also requires the payment of something called up-front mortgage insurance (UFMI). The UFMI requires those applying for a loan, to pay 1% of the value of the loan up front when the loan closed, according to the Mortgagee letter 2010-28 released by the U.S. Department of Housing and Urban Development (HUD). You have the option to pay this amount in cash when you close your loan, but most people choose to roll it into their total mortgage amount.
If you can afford to pay this amount up front, it's a good idea to do so, because if you roll it into your loan, it will be a lot more expensive in the long run. Let's say your home costs $250,000, you put down the FHA's required minimum of 3.5% (250,000 x 0.035 = 8,750), and your mortgage covers the remaining $241,250 (250,000 - 8,750 = 241,250). On a 30-year mortgage, with a 6.5% interest rate, the original $2,412.50 UFMI (241,250 x 0.01 = 2,412.50) will ultimately cost you about $5,491.77.
If you want to do yourself the favor of actually paying the UFMI up front, you'll need to have more savings before you buy. Of course, increasing your down payment from 3.5% to about 4.5% (technically, to 4.47%) from $8,750 to $11,162.50, or an extra $2,412.50 (the cost of UFMI), would have the exact same effect on your long-term finances.
How Does FHA Mortgage Insurance Differ from Private Mortgage Insurance?
The annual cost of a FHA mortgage insurance changes depending on the down payment provided. As of April 2011, HUD has changed the FHA mortgage insurance to 1.10%, with a down payment greater or equal to 5%. For those who have less then 5% down payment, are required to pay an insurance premium of 1.15%. So, on a $250,000 home with a minimum down payment of $8,750 (3.5%), your monthly mortgage insurance premium would be based on a loan amount of $241,250, and cost $231.20 per month. This amount must be paid with your monthly mortgage payment.
PMI, by contrast, might cost as much as 1.15% of the loan balance, per year, or $231.20 per month in this example depending on our credit score. The difference lies in the requirements. PMI requires you to possess an excellent credit rating of over 720 to receive a rate of about 1.15%n according to the Monthly Premium & PMINU Monthly rates provided from PMI in May 2011. If your credit score is lower, you will be required to present a larger down payment before they offer you any type of insurance. FHA mortgage insurance only requires a minimum credit score of 580 to be eligible for 3.5% down payment, but most lenders require a credit score of 620-640, which still allowing you to buy a home sooner. Thus, if you have to have mortgage insurance, FHA mortgage insurance can be the lesser of two evils. Under 2011 federal legislation, mortgage insurance premiums are tax deductible, so whether you have regular PMI or FHA mortgage insurance, the tax deduction can soften the blow, but check with your accountant to see if you meet the proper requirements to receive this tax deduction. (Read 6 Reasons To Avoid Private Mortgage Insurance to learn more on why the FHA insurance is the lesser of these evils.)
An advantage that PMI sometimes has over FHA mortgage insurance is that not all lenders require a mortgage insurance payment up front like the FHA's UFMI.
Who Must Carry FHA Mortgage Insurance and for How Long?
As of February 2011, when you get a FHA loan, you can put down as little as 3.5%. But, just like with conventional loans, in exchange for the privilege of putting so little money down, you'll have to pay mortgage insurance until your loan-to-value ratio is high enough - in other words, until you have paid off a certain amount of the loan. You are also required to pay a higher insurance premium. When your equity is high enough (22% in the case of a FHA loan), the lender becomes much less worried that you will walk away from the home, if you start having trouble making your monthly payments. On the same $250,000 house, from our earlier example, when you first bought it and were required to take out mortgage insurance, your only loss, if you walked away from the house, would have been your $8,750 (3.5%) down payment. While this is no small chunk of change, it's a whole lot less significant than walking away from $55,000 (or 22% of the total cost).
According to the HUD, those with loans greater than 15 years are required to make monthly mortgage insurance payments for five years, and have a 78% loan-to-value ratio (meaning that you have paid 22% of the loan's principal, including your original down payment), before insurance is not longer needed. If you posses a loan with less then 15 years, then the only requirement is the 78% loan-to-value ratio. (To learn more, read Conquering The LTV Calculation.)
How Can You Avoid or Get Rid of FHA Mortgage Insurance?
Because FHA mortgage insurance adds a significant expense to the cost of homeownership, you're probably wondering if there's anything you can do to reduce or avoid it, and at what point are you allowed to get rid of it.
The easiest way to avoid mortgage insurance, of course, is to put down 20%. You can do this by waiting to buy until you have more savings, or in some cases, by purchasing a less-expensive property, where you can afford to put down 20%. Of course, realistically, if you are looking at a FHA loan with 3.5% down, you are probably walking a fine line between being able to afford any mortgage at all, and having to keep renting.
If home prices appreciate, significantly, after you buy, you may be able to refinance your way out of PMI. For this to work, your home's value will need to have appreciated enough to give you 22% equity in the home.
If you can't refinance to increase your loan-to-value ratio, you can always make extra payments towards the principal to increase your ratio faster. Not only will this help you get rid of mortgage insurance faster, it will also help you pay your house off faster, reducing the amount of interest you'll pay over the long run and increasing your savings even more. If you take this route, you will need to contact your lender to get your mortgage insurance canceled. (Read our related article Paying Off Your Mortgage for more good reasons to retire this debt sooner rather than later.)
Some lenders may offer special loan programs that do not require the payment of monthly mortgage insurance premiums, despite allowing a low down payment. Quicken Loans, for example, has a program called "PMI Buster" for borrowers who can put down at least 5%. However, borrowers should expect that while lenders offering programs similar to this one might not require traditional PMI, they will make up for the increased risk of lending to you in another way, such as by offering you a higher interest rate. Indeed, this is the case with the PMI Buster loan product, which advertises "a lower payment by eliminating traditional PMI with lender paid mortgage insurance (LPMI). LPMI can be built into your mortgage rate."
If all else fails, one day you will reach 78% loan-to-value ratio simply by making your monthly mortgage payments. On the $250,000 home purchase we've been discussing throughout this article, you would reach 22% equity after 11 years and nine months. This means that you will pay a total of $32,599.20 (141 x $231.20 = $32,599.20) in monthly mortgage insurance premiums until you're able to cancel the insurance.
Note: Your lender is supposed to automatically drop mortgage insurance when you reach this point on a FHA loan.
Is It Worth It?
When considering a low down payment loan, think about whether the extra cost of both the up-front mortgage insurance and the monthly mortgage insurance premiums are worth it to you to get a house sooner. It's hard to calculate whether you'll win or lose financially, in the long run with this arrangement, since you can't predict what housing appreciation rates will be between the time when you have 3.5% to put down and the time when you have 20% to put down. You also can't predict, accurately, how many years it would take you to save the extra 16.5%, because incomes and expenses can change, for better or worse, in ways no one can anticipate. For these reasons, it may be best to decide on a psychological basis whether you are comfortable with paying the extra money required for mortgage insurance in order to have a place to call your own.
For further reading on purchasing that first home, be sure to read Financing Basics For First-Time Homebuyers.