I spent much of the day after Thanksgiving in my garage untangling last year’s Christmas lights and taking down the decorations from their perch in the garage. While replacing bulbs and wrestling down boxes, I was listening to a radio infomercial on FHA mortgages. The talk-show host was bloviating about all the benefits of a FHA mortgage. What I heard was technically correct. FHA allows a borrower to finance a home purchase with only 3.5 percent down payment, their credit score need only be 640 or better and underwriting is more flexible than conventional Fannie Mae. I did find the program a bit misleading. While the mortgage person did a good job of explaining all the benefits of a FHA loan, he did not discuss their serious side effects. Today’s Full Disclosure column will.
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The Federal Housing Administration has been financing homes since 1934. The agency doesn’t actually lend money to borrowers but insures the lender’s in the event of a borrower’s default. Historically, FHA loans were the first choice of low-income or first-time borrowers with some exceptions. In California and other high cost housing states, FHA loan limits severely restricted their use. During the 1990s, less than 10 percent of all loans originated in California were FHA insured.
It was Congress that controlled the FHA loan limits which were often set unrealistically low. The more homes increased in value, the less applicable was FHA financing. Between 2000 and 2006 the percentage of FHA loans across the country dropped from 18 percent to 1.8 percent. The demand, however, for easier qualifying, low down payment loans still existed. The void was filled by the subprime loans. When the subprime loans disappeared, and Fannie and Freddie were placed into conservatorship, FHA became the go to choice for loans. The market share increased to 30 percent by 2010.
There are reasons why banks and mortgage originators are attempting to sway borrowers toward using FHA financing. Qualifying for conventional loans, already a difficult and cumbersome process, is scheduled to get worse. New federal regulations, under the Consumer Finance Protection Bureau, will take effect in January and add another layer of loan guidelines in determining if a borrower is qualified or not. The new “Qualified Mortgage” takes into consideration whether or not the mortgage payment is considered “affordable.” A borrower could qualify under the old guidelines and not under the new.
Another reason for the push to attract FHA borrowers is the declining number of conventional loans. Home sales have been tapering off since late spring and refinance activity has nearly disappeared. As of last week, refinancing loan applications are down 60 percent from this time last year. Lenders need to keep their pipeline full of new loan applications and FHA loans are likely the best source of new business. So what’s the problem with a loan program that helps these borrowers own a home? The costs.
With the exception of VA loans, mortgage insurance (MI) is a loan requirement for all borrowers with less than a 20 percent down payment. This insurance pays the lender in the event the borrower defaults on the loan. With conventional loans, the amount of MI depends upon the down payment. A borrower who only has a 5 percent down payment will pay about 1 percent of the loan amount yearly amortized over 12 months. As an example, on a $300,000 loan amount, the MI would be $250 a month. If the borrower has a 10 percent down payment the mortgage insurance drops to .67 percent or $167 a month and less with a larger down payment. MI can be cancelled usually after the borrower has 20 percent equity and certain other requirements are met. Assuming a 95 percent borrower kept their loan for five years before they were able to cancel their MI, they would have paid $15,000 in mortgage insurance.
FHA has two charges for mortgage insurance: upfront and monthly. The upfront fee is 1.75 percent of the loan amount and is added to the loan. Using the same $300,000 example above, that loan would be $305,250. In addition, FHA charges a monthly MI of 1.35 percent regardless of the amount the borrower has for a down payment. On our $300,000 loan example, that works out to $337 a month.
When comparing the sample conventional and FHA loans, the conventional MI totals $15,000 over five years while the FHA MI costs $20,220, plus the upfront fee of $5,250. But wait there’s more. While conventional MI can be eliminated when a borrower has 20 percent equity, the FHA MI cannot. The MI remains for the life of the loan. That’s about $121,000 for a 30-year loan. Yes, you can always refinance to rid the loan of MI but refinancing today’s FHA’s 4.25 percent interest rate with future higher rates to eliminate the MI may not make sense either.
FHA loans haven’t always been this costly. My first home was financed with a FHA loan and hundreds of my clients over the years have been able to buy a home with a FHA mortgage. But FHA today should be considered a last financing option. It is a costly subprime loan. If Wells Fargo added a $5,250 premium to a borrower’s non FHA $300,000 loan, someone would go to jail. Saving for a 5 percent down payment and improving credit are better alternatives.
Ken Calhoon is a real estate broker in El Dorado County. He can be reached at [email protected]