(Updated February 2015)
On the strength of renewed federal support, the FHA is poised to pick up the pace of insuring mortgage loans. If you're in the market to buy or refinance, take a few minutes to learn how this important mortgage financing option works.
If the Federal Housing Administration (FHA) were to start running advertisements, the slogan might be: "We're the FHA. We don't make loans, we insure them." While there is a lot of discussion out there about FHA mortgages, many prospective borrowers still have questions about the agency's role in the process, and the insurance that makes these loans possible.
To set the record straight, the FHA establishes guidelines for various types of mortgages. These guidelines include more lenient qualification standards, and more attractive loan terms. Lenders agree to these parameters because borrowers are obligated to purchase FHA mortgage insurance. This provides the lender with added protection against losses resulting from a potential borrower default.
This means FHA mortgages have more lenient credit requirements than most other types of mortgages, particularly those backed by Fannie Mae and Freddie Mac. Average FICO scores on approved FHA mortgages average about 680, while those for Fannie and Freddie average around 740.
No free lunch
The premiums for FHA mortgage insurance are paid by the borrower. On 30-year loans, there's an upfront cost of 1.75 percent of the loan amount, plus an annual premium of 0.85 percent on loans with the minimum 3.5 percent down payment. This annual premium is charged along with the monthly mortgage statement, so it actually breaks down into 12 monthly premiums for all practical purposes.
On a $180,000 mortgage (the FHA average), that works out to an upfront premium of $3,150, which can be rolled into the loan amount instead of being paid separately. The annual premium works out to $1,530 per year, or $127.50 a month.
The annual fees vary depending on the size of the down payment, the length of the loan and the loan amount. For 30-year loans with a down payment of 5 percent or more, the annual premium is 0.80 percent. On 15-year fixed-rate loan, the annual premium is 0.70 percent for loans with less than 10 percent down, 0.45 percent for loans with down payments or equity of 10 percent or more.
For jumbo mortgages, those with loan amounts in excess of $625,500, figure to add another 0.20-0.25 percentage points onto the figures above.
For how long?
Until recently, borrowers were not obligated to pay the monthly premiums indefinitely. However, changes to the loan program now require that for new FHA loans with less than 10 percent down or 10 percent equity (in the event of refinancing), annual mortgage insurance must be carried for the life of the loan, either 15 or 30 years. Loans with down payments or equity of 10 percent or more may have mortgage insurance canceled after 11 years.
FHA loans that were originated prior to the rule change in June 2013 are unaffected and can still cancel their mortgage insurance once they reach a 78 percent loan-to-value ratio on their mortgage balance; that is, the amount they owe is no greater than 78 percent of the home's value.
Lower premiums on streamline refinancing
Special savings on mortgage insurance premiums are available to borrowers who obtained an FHA mortgage prior to June 1, 2009 and use the FHA streamline refinance option to refinance their mortgage to a lower rate or different loan term. This is an expedited refinance process for current FHA mortgage holders that eliminates the requirements for a property appraisal, income and employment verification, and credit checks, as long as you have stayed current on your mortgage payments.
For these borrowers, the upfront mortgage insurance premium is a mere 0.01 percent, or $18 on a $180,000 mortgage. What's more, they're grandfathered into the old annual premium of 0.55 percent, no matter how much equity they have.
On the downside, however, they lose the ability to cancel the mortgage insurance premiums if they have less than 10 percent equity and can only cancel after 11 years with the new loan if their equity is 10 percent or more.
However, just because you have less than 10 percent equity doesn't mean you'll have to pay mortgage insurance premiums for 15 or 30 years, whatever the length of your loan is. You can always refinance into a non-FHA mortgage once you reach 80 percent equity and eliminate the need for mortgage insurance that way. However, it may not be desirable to do so if mortgage rates have risen significantly in the meantime.
Further questions about FHA mortgage insurance should be directed to a reputable and experienced FHA lender.