Insuring Federal Housing Administration Mortgages

If you lend money to someone with a less-than-perfect borrowing track record, you’ll want a guarantee that you’ll get repaid. That is the underlying principle behind mortgage insurance. Although it protects lenders from loss, you may consider it a nuisance. After all, it is another cost you have to shoulder to realize your dream of becoming a homeowner. Still, if it didn’t exist, lots of people probably wouldn’t qualify for loans at all until they had higher down payments.

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. While there are many different kinds of mortgage insurance, this article looks at the basics of Federal Housing Administration (FHA) mortgage insurance.

FHA Mortgage Insurance: An Overview

FHA loans are attractive to many consumers, especially first-time homebuyers. That’s because they have a lower down payment requirement—3.5%—as well as lower thresholds for income and credit. That means someone with a credit score as low as 580 may qualify. And someone with a credit score between 500 and 579 can still qualify with a 10% down payment.

All FHA loans require borrowers to take out mortgage insurance. FHA mortgage insurance protects the lender because borrowers—particularly new ones—pose a higher risk of default when they have minimal equity in their homes. In essence, they may not have that much to lose by walking away and letting the bank foreclose on the property.

The FHA requires two types of mortgage insurance on its loans. Borrowers must pay up-front mortgage insurance (UFMI)—1.75% of the loan balance—along with annual mortgage insurance premiums (MIPs) based on the total value of the loan. Annual MIPs range from 0.8% to 0.85% for base loan amounts of $625,500 or less. For those exceeding this amount, the annual MIPs vary between 1% and 1.05%. These rates apply to loan terms of more than 15 years. Mortgages that are financed for 15 years or less come with rates of 0.45% to 0.95%.

Example of FHA Mortgage Insurance

To demonstrate, here’s how much you’d pay in FHA mortgage insurance with a $300,000 loan:

• Mortgage Amount: $300,000
• Down Payment: $10,500 (3.5% of $300,000)
• Loan Amount: $289,500
• UFMI: $5,066.25
• Annual MIP: $2,460.75 each year ($205.06 per month)

Keep in mind that this scenario assumes that you pay the UFMI right off the bat. In actuality, you do have the option of rolling the amount into your total mortgage amount. Nevertheless, it’s a good idea to pay it in full at the beginning if you can afford to do so. If you do decide to include it in your loan, you’ll pay more in the long run. Not only does it increase your loan amount; it also increases your annual mortgage insurance premium payment.

FHA Mortgage Insurance Terms

According to the U.S. Department of Housing and Urban Development (HUD) website, the length of time FHA mortgage insurance premiums must be paid vary based on the amount and length of the mortgage. A loan-to-value ratio (LTV ratio) equal to or less than 90% requires mortgage insurance for 11 years.

When you first start paying your mortgage, you're at a higher risk of default, so your premiums will be higher. That’s because, as mentioned above, you don’t have much equity built into your home, so you only lose the $10,500 down payment if you default in the first year on that $300,000 home. Your premium payments decrease the longer you pay your mortgage. You’ll be less likely to want to leave your house and default on your loan later on.

Avoiding or Getting 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, as well as at what point you are allowed to get rid of it.

The easiest way to avoid mortgage insurance is to put down 20%. You can do this by waiting to buy until you’ve saved more or by purchasing a less-expensive property. Of course, if you’re looking at an FHA loan with 3.5% down, you’re probably walking a fine line between being able to afford any mortgage at all and having to keep renting.

If home prices significantly appreciate after you buy, you may be able to refinance your way out of mortgage insurance. For this to work, your home’s value will need to appreciate enough to give you 22% equity in the house. If you can’t refinance to increase your LTV ratio, consider paying down your principal balance. Not only will this help you get rid of mortgage insurance more quickly; it will also help you pay your house off faster. That reduces the amount of interest you’ll pay over the long run. If you take this route, you will need to contact your lender to get your mortgage insurance canceled.

Some lenders may offer special loan programs that don’t require monthly mortgage insurance premium payments, despite allowing a small down payment. That makes it vital to shop around.

FHA vs. Private Mortgage Insurance (PMI)

There is an alternative to FHA mortgage insurance: private mortgage insurance (PMI). You may be required to buy PMI as a condition if you have a conventional mortgage. As suggested by the name, it is provided by a private insurance company and arranged by the lender. Just like FHA mortgage insurance, PMI protects the lender, not the borrower.

You must purchase PMI if your down payment is less than 20% of the total loan. Many lenders also require PMI when you refinance your mortgage with a conventional loan and the equity is less than 20% of the property value. However, there’s a big difference between FHA mortgage insurance and PMI: Not all lenders require an upfront mortgage insurance payment.

PMI can cost anywhere between 0.2% to 2% of the total loan value annually, so a mortgage of $200,000 will cost you as much as $4,000 more each year at the maximum rate of 2%. Of course, your rate depends on your credit score—the better your credit, the lower the rate. If your credit score is lower, you will need a larger down payment before you’re offered any type of insurance.

FHA mortgage insurance requires a minimum credit score of 580 to be eligible for a 3.5% down payment. However, most private lenders require a credit score of at least 620, which still allows you to buy a home sooner. If you have to have mortgage insurance, the FHA kind can be the lesser of two evils.

Know that there has been considerable discussion about the impact of redlining and other forms of discrimination in the private mortgage insurance industry. Although many private mortgage insurers do not discriminate, be aware that it can happen and report it promptly.

The Bottom Line

When considering an FHA loan with a small down payment, think about whether the UFMI and the monthly MIPs are worth it to get a house sooner. It’s hard to calculate, because you can’t predict what housing prices will be when you have more money for a down payment later. It may be best to decide on a psychological basis whether you are comfortable with paying the extra money required for mortgage insurance.