FHA Loans and PMI

FHA loans are quite popular nationwide. They are loans made by traditional lenders but backed by the government, guaranteed against default. FHA loans are made on qualified properties with one to four dwelling units, for up to $417,000 for a single-dwelling property ($729,750 in some high-cost metro areas).

One of the most attractive features of an FHA loan is that the down payment can be as low as 3.5 percent of the purchase price. By comparison, conventional loans with the best terms generally require 20 percent down. FHA lending guidelines are more forgiving in general, allowing for a lower credit score and higher debt to income ratio.

FHA loans are more expensive

An FHA loan is typically more expensive than a conventional loan. A borrower can be approved despite having less than stellar credit, but will pay a higher interest rate. Private mortgage insurance (PMI) is required on any mortgage with a loan-to-value ratio of greater than 80 percent. In other words, on any loan on which the borrower pays less than 20 percent down.

In the past, an FHA borrower could cancel PMI once his or her equity reached about 22 percent. In some cases, particularly when property values rise, a few years of payments and a refinance with a new appraisal would do the trick to bring the borrower’s equity up to the minimum threshold.

This year, however, rules about PMI on FHA loans changed.

New rules for PMI on FHA loans

The FHA now requires that all borrowers pay for two forms of insurance. The up-front mortgage insurance premium, or UFMIP, and the annual mortgage insurance premium, or MIP.

The UFMIP is currently 1.75 percent of your loan size. It is a one-time premium added to your loan amount. It is not counted against you in your loan-to-value calculation. The major and significant downside is that the borrower must then pay mortgage interest on the UFMIP for the entire life of the loan.

The MIP rate maxes out at 1.55 percent annually. It is paid in monthly installments, bundled together with your loan payment and, in most cases, property taxes and homeowner’s insurance premium. Previously, certain FHA loans with a loan-to-value ratio of 78 percent or less were exempt from MIP payments. That is no longer the case.

MIP cannot be cancelled, no matter the borrower’s level of equity in the home, if the starting loan balance is greater than 90% of its appraised value. So any borrower taking advantage of the 3.5 percent minimum down payment requirement will pay MIP for the entire 30-year life of the loan. If the starting loan balance is 90 percent or less (meaning the borrower paid at least 10 percent down), MIP may be cancelled after 11 years.

The PMI policy changes affect a very large number of FHA borrowers who take advantage of the low down payment requirements. However, many FHA borrowers have no other option to buy a home and will pay the premiums rather than forego the purchase.

The polices are in direct response to the housing market bust. Borrowers dropped their mortgage insurance when property values escalated. When the borrower became unable to make the payments, the FHA was stuck paying the bill to the lender while values plummeted.

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Published September 13, 2013 Updated: February 18, 2014
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