Many home buyers with past credit problems and lower down payments turn to the Federal Housing Administration or FHA to help them get a mortgage. FHA mortgages are not issued by FHA; they are underwritten by FHA approved lenders who have more credit and income flexibility in their underwriting standards so people who may not otherwise be able to get a home loan can get one. It is possible for a borrower with a 600-credit score and a 3.5% down payment to be approved for an FHA mortgage in some situations. And the borrower can often get that loan at a rate below conventional rates. What a deal!
But as with almost everything in life, nothing is for free. With FHA mortgages, you must pay for mortgage insurance at closing and annually. This is referred to as MIP. FHA assesses a 1.75% upfront mortgage premium when the loan closes. Then, it charges the buyer a varying rate each year; most common it is 1.35% of the loan value. The borrower pays that premium each month as part of their mortgage payment.
FHA loan holders are not the only ones who must pay mortgage insurance. On conventional mortgages that are supported by Fannie Mae and Freddie Mac, you must pay PMI or mortgage insurance when you have less than a 20% down payment. Once you have reached 20% equity through mortgage payments, appreciation or a combination, you can have PMI removed.
June 1, 2013
It used to be that you could do the same thing with FHA loans. In 2013, it was determined that the FHA’s Mutual Mortgage Insurance Fund or MMI was short of money. This fund is used to pay default claims when buyers cannot pay their loans anymore. Federal law dictates there must be a minimum amount of funds in MMI – $2 for every $100 that is insured by FHA. As of an audit in 2013, FHA had -$1.44 for every dollar it insured.
That is why FHA had to change its rules. In the past, FHA required homeowners to pay MIP as long as their loan to value was more than 78%, where the value assumed was whatever the last known value was, such as at loan closing. Also, if the loan term was more than 15 years, at least 60 payments had to be made before FHA could cancel MIP.
But as of June 1, 2013, this changed. All loans closed on that date and afterwards that had a down payment of 10% or more could only have MIP cancelled after 11 years. Loans that have less than a 10% down payment must pay MIP for the entire term.
This means if you buy a home with an FHA loan with 3.5% down, you must pay for MIP for all 15 or 30 years of the loan term. This may seem very unfair, especially for people who have far more than 20% equity in their property after years in the home. But this is the price you pay for getting approved for a loan through FHA.
Of course, FHA rules change often. It is possible this rule could be changed in the future, but as of today, MIP is forever if you put down less than 10%.
The silver lining to this unfortunate situation is that if you have a better credit situation and are paying your loan on time, you do not need to keep your FHA loan forever. If the interest rate environment gets to a point where you can refinance at the same or even a lower rate into a conventional loan, you may be able to do so without paying mortgage insurance.
With a conventional loan and at least a 20% down payment, you can get a loan without any mortgage insurance. You will simply need to make sure you have suitable credit to be approved for a conventional loan. Lending standards for conventional loans are stricter than FHA. You will generally need a credit score of 640 to be considered and will have to pay a higher rate at that FICO score. The best conventional rates go to those who have well over a 700 FICO score.
The bottom line with FHA loans is this is a great program for people with average or even poor credit. Some people with past bankruptcies or foreclosures will have difficulty being approved for a conventional loan. FHA is often the last resort, and it really is a good deal. MIP is the only major problem though. Just keep in mind that you need to get your credit score and payment history in order if you ever want to refinance the FHA loan so you do not need to pay mortgage insurance after you achieve 20% equity.