FHA home loans are just that because you pay an FHA Mortgage Insurance Premium (MIP) to the Federal Housing Authority to insure the lender against loses they would take in the event that you defaulted on your promise to pay the loan back as dictated in the promissory note.
As of October 4th, 2010 changes are taken place regarding the FHA mortgage insurance premium and it will affect your monthly payment.
First lets start with a little education. If it were not for private mortgage insurance, VA or FHA, all traditional type of loans would require a minimum down payment of 20%. There are essentially four criteria a lender will look at in order to make a decision on whether or not to loan you money.
1. Your ability to pay – This is why they check your income sources and the likelihood of a continued stream of income.
2. Your willingness to pay – This is why they check your credit, to see if you pay your obligation on time and as agreed.
3. The collateral – This is why a lender will request an appraisal and in some cases an external home inspection. They want to ensure that they are basing their loan amount on the proper true value of the property.
4. The risk – How much risk do you burden and now much risk does the lender carry. This is where the down payment comes into play.
Let’s discuss the risk factor. The assumption is that the more “skin you have in the game” or, the more of your own money that is tied up in this property the more likely you are to do whatever it takes to make the payment so that the lender does not foreclose on the property.
This makes sense. Its one thing to have your life and all your belongings tied up in the house you live in but you add a whole new element if you have put $40,000 of your own money into the purchase of the home.
This is also why down payment requirements and interest rates are much higher for investment properties. If you were to lose your income and were faced with a decision, make my home payment or make my renters house payment it would probably take you a nanosecond to come to the right decision.
Not too long ago a 50% down payment was the going rate. With a strong US economy lenders slowly gravitated to a 20% down payment requirement. Simply put, lenders were comfortable knowing you would do whatever you needed to do to save your house and money.
However, the US Government has a strong initiative to prop up the housing industry and encourage home ownership. On top of that, simple statistics came into play and smart entrepreneurs put the numbers together to come up with yet another profitable insurance opportunity.
They figured, by spreading the risk among many, they could cover the down payment requirements, take the hit on the few, and make a nice profit.
Of course, the insurance companies did not want to have to come up with the 20% down payment, they would rather continue to have their money working and earning interest. The proposal was simple; if the lenders were willing to loan up to 95% the insurance company would cover the 15% if the lender were forced to repo the home (foreclosure).
This seemed like a win-win for the lenders, they could surely sell the home quickly at 80% of its value to remove it from the books. The insurance companies would win knowing that the foreclosure rate would be somewhere around 3%, the many would cover the few through monthly premiums.
And thus, Private Mortgage Insurance was born (PMI).
That is a very simple overview of how it works. If you were to apply for a traditional home loan (conventional financing) and put only 5% down you would be required to pay PMI to cover the lenders risk.
Because this is private the rates vary but you could expect to pay.85% annually of the loan amount prorated monthly. For example; on a $200,000 loan you would add about $141 to your monthly payment.
The more money you put down the lower this monthly rate would be. And, if your property appreciated in value, coupled with loan principal reduction, you could ask the premium to be lowered (of course you would have to pay for an appraisal to lower this monthly payment slightly, not worth it most of the time).
When using conventional financing there is no upfront payment only monthly.
Now, seeing this business model as one that would work, the Government saw a great opportunity to jump in and spring the home ownership initiative in fast forward.
So essentially, FHA home loans were born. They work in the much of the same manner as the private sector.
There are two major exceptions:
1. Because FHA is taking most of the risk they get to dictate the guidelines in which a borrower can be approved.
2. FHA charges an Up Front premium as well as a monthly premium. AND, the upfront portion can be financed into the loan amount.
So here is the skinny. In my opinion FHA home loans are the absolute best option for most first time home buyers. But it comes with a price (as all loans do).
As of October 4th, 2010 to borrow money from a lender insured by the FHA you will be required to pay…
A 1% Up Front mortgage insurance premium that can be added to the loan amount.
.9% or 90 basis points annually prorated for a monthly premium.
Example: The home you want to make an offer on has been negotiated to cost you $200,000. You are using FHA so you can keep your down payment requirement to the low 3.5% (10% if your credit score is between 500 – 570. Good luck getting any conventional financing with those scores).
* Down Payment – $7,000
* Loan Amount – $193,000
* Upfront MIP – $1,930
* New Loan Amount – $194,930
* Annual MIP – $1,754.37
* Prorated monthly – $146.20
The figure above that is most important to you is the $146.20 added to your payment each month. So when qualifying for a loan this must be added but you cannot add it until you know the loan amount (the chicken or the egg).
Yes, mortgage insurance can be expensive and is more expensive with FHA financing but look at the trade-offs. The big one is your low down payment requirement with FHA home loans. This allows you to keep more money in your pocket to help with moving expenses, furnishings or better yet, letting that money continue to earn interest.