The Quick & Dirty Guide To FHA Mortgages
Peter G. Miller
© Copyright 2010 Peter G. Miller, All Rights Reserved
The Silver Spring Press
Version 2010-0003
Smashwords Edition
Table of Contents
Part 1: In The Beginning
Term Mortgages
The FHA Is Created
What makes the FHA different?
Interest Rates
Part 2: FHA Insurance
Why Do You Need FHA Insurance?
Canceling FHA Mortgage Insurance
FHA Refunds
Where's The Premium Money?
FHA Reserves
FHA Foreclosures
FHA Loan Limits
Part 3 -- FHA Loans Today
The FHA's Most Popular Loan: 203(b)
Reverse Mortgages
203(k) Buy & Repair Loans
Title 1 Property Improvement Loans
Streamline Refinancing
Part 4 -- Loan Qualifications: How Much Can You Borrow With FHA Financing?
Credit Scores
FHA Loans & Lender Layering
Appraisals
Seller Contributions
Gifts
What About FHA Loans & Investors?
FHA Loans & Flipping
Part 5 -- How To Successfully Apply For An FHA Mortgage
Important Loan Application Points
How To Use Good Faith Estimates
Back Pages
Get 'Em While They're Hot -- Additional Titles In This Series
About The Author
Notices
Part 1: In The Beginning
In the late 1920s and through much of the 1930s most Americans felt the sting of hard times. The stock market crash in 1929 followed by the Great Depression left millions of people poor and unemployed.
It was at this time that the government developed a series of programs to get the country back on its feet, programs we take for granted today. The Social Security Act was passed in 1935. Massive public works projects were undertaken, including the construction of the Hoover Dam (started in 1931) and the Grand Coulee Dam (1933). The Tennessee Valley Authority was created in 1933 and rural electrification brought power for the first time to millions. Most of the monumental buildings which now make up the Federal Triangle in Washington, DC were build during the 1930s.
These and other projects put millions of Americans back to work. In addition, an effort was made to reform Wall Street -- sound familiar? The Securities and Exchange Commission was established in 1934. To reduce risk, the Glass-Steagall Act of 1933 divided the banking world into commercial banks that took deposits and investment banks that did not. The Federal Deposit Insurance Corporation (FDIC) was created in 1933 to protect bank depositors.
Term Mortgages
Meanwhile, there was the matter of mortgages. Most Depression-era home loans were in the form of five-year term mortgages. The way they worked was that you got a loan for five years, made your payments, and then refinanced.
The system was fine until lenders stopped refinancing. The logic was that since the value of homes had declined, mortgages of the same size could not be renewed. Smaller loans, maybe, but smaller loans meant existing loans first had to be repaid and that would require a combination of a new loan and cash. Most borrowers, of course, did not have such cash.
Example: Watson had a $5,000 mortgage in the form of a five-year term loan. To refinance at the end of five years he needed $4,522 to cover the unpaid balance if he had 4% financing and a 30-year payment schedule -- a huge balloon note equal to almost the original debt. However, since the value of his home had declined the bank would now only lend him $4,000. Watson would need $522 in cash to pay off the loan.
This may not seem like a lot of money today, but according to the Bureau of Labor Statistics in 1933 there was a 24.9 percent unemployment rate. The national minimum wage at the time was 25 cents an hour, so at the end of a 50-hour week a worker might earn $12.50. A lot of people lost their homes.
The FHA Is Created
The term loan system was awful and as an alternative the federal government decided to do something: It created the Federal Housing Administration (FHA) in 1934.
Today -- more than 37,000,000 FHA loans later -- the FHA is part of HUD, the Department of Housing and Urban Development.
What makes the FHA different?
First, the FHA does not make loans. Instead it insures mortgages which meet its standards. In other words, you get your loan from a private-sector lender. The lender then insures the loan under the FHA program and the FHA in turn will only insure the mortgage if the loan meets its standards.
Second, the FHA revolutionized mortgage lending. How? It offered to insure loans with a 20-year term. Not only that, FHA-backed loans were self-amortizing. There were no balloon payments at the end of the loan term, instead the mortgage would be completely repaid and the property would be owned free and clear. Lenders could still offer their five-year term loans, but who would want one when FHA financing was available? The term loan concept died in the U.S. as private lenders scrambled to offer competing 20-year mortgages.
The importance of a 20-year term is this: The loan does not have to be refinanced every five years as with term financing. That means once an FHA loan is in place, if the borrower runs into hard times, the loan will not be foreclosed unless the payments are missed. There's no need to go back to the lender every five years to re-qualify.
Third, if it’s an FHA mortgage you can be certain that the loan features little down, forbids prepayment penalties and does not contain those infamous “gotcha” clauses found in toxic mortgages.
Interest Rates
FHA interest rates are established in the marketplace and not by federal regulation. This, however, was not always the case: HUD actually set FHA rates until November 30, 1983, a practice that ended with enactment of the Housing-Urban Rural Recovery Act of 1983.
Because interest rates for FHA loans are now determined by the market, it makes sense to shop around for the best rates -- the terms of all FHA loans in a given category -- 203(b), HECM, etc. -- are exactly the same so the core issue for borrowers is price.
Part 2: FHA Insurance
You must pay a fee to use FHA insurance called a mortgage insurance premium or MIP. There are two forms of MIP with 203(b) loans, the most popular FHA program.
An up-front MIP at the time you close your loan. At this writing the up-front MIP is equal to 1.75 percent of the loan amount, however the premium will increase to 2.25 percent for most FHA loans made after April 5, 2010. The up-front MIP can be added to the loan amount. Example: You borrow $220,000. The MIP is $4,950. ($220,000 x 2.25%). You can add this sum to the loan amount.
An annual MIP. At this time the annual MIP is equal to .55 percent of the outstanding loan amount, paid monthly. If your outstanding balance is $198,000 then your monthly MIP is equal to $90.75 ($198,000 x .55 divided by 12). In other words, your monthly mortgage payment includes mortgage principal, mortgage interest, property insurance and property taxes PLUS the FHA insurance premium.
Why Do You Need FHA Insurance?
If you buy health insurance and come down with a covered disease the insurance company will step in to pay its share of the bills (or, at least it should). In the case of health insurance you (or your employer) pay the premiums and you're the beneficiary of the insurance.
With FHA insurance you pay the premiums and if something goes wrong -- if the property is foreclosed -- the lender is the beneficiary, the lender gets the cash. Indeed, the FHA covers 100 percent of the mortgage amount.
Huh? Why should YOU buy insurance that benefits the lender?
When you buy real estate lenders will gleefully provide loan a loan if you'll make a 20 percent downpayment. Without 20 percent down or some sort of strong third-party payment guarantee lenders will not put up a dime.
FHA insurance is one form of third-party backing. With FHA financing you can buy with 3.5 percent down plus closing costs.
Why will lenders let you buy with only 3.5 percent down under the FHA program? Because the insurance provided by the FHA is a substitute for a huge downpayment.
Imagine that you buy a home for $300,000. If you need 20 percent down you would have to bring $60,000 to settlement, plus closing costs. With 3.5 percent down you only need $10,500 up front for the downpayment. Your cash requirement to close drops by nearly $50,000.
The FHA program makes it possible to buy a home without waiting for a lifetime to accumulate downpayment money. For most people who have held real estate over the span of many years that's been a very good deal.
Canceling FHA Mortgage Insurance
Generally the FHA MIP for 203(b) is automatically canceled after 15 years or if the loan-to-value (LTV) ratio of the mortgage falls to 78 percent. The MIP cannot be canceled in less than five years.
“In the past," says HUD, "some FHA borrowers have paid annual mortgage insurance premiums throughout the life of their mortgages. Effective for all loans closed on or after January 1, 2001, FHA’s annual mortgage insurance premiums will be automatically canceled under the following conditions:
“For mortgages with terms more than 15 years, the annual mortgage insurance premiums will be canceled when the loan to value ratio reaches 78 percent, provided the mortgagor has paid the annual mortgage insurance premiums for at least five years.
“For mortgages with terms 15 years and less and with loan to value ratios 90 percent and greater, the annual mortgage insurance premiums will be canceled when the loan to value ratio reaches 78 percent, irrespective of the length of time the mortgagor has paid the annual mortgage premiums.
“Mortgages with terms 15 years and less and with loan to value ratios of 89.99 percent and less will not be charged annual mortgage insurance premiums.”
FHA Refunds
When the FHA was first established it was designed as a mutual insurance program. This means that borrower -- the equivalent of policyholders in a private mutual insurance company -- would benefit when the program made a profit. In the case of the FHA, the way this was done was to pay borrowers a refund after their loan was paid off by refinancing the debt or selling the property.
"The borrower's regular mortgage payment, said the FHA in a 1959 history of the program, "would include a mortgage insurance premium which the lender would pay annually to the FHA. In time the accumulation of premiums would make the agency self-supporting and possibly provide dividends for mortgagors. The system was similar to that used by private mutual life insurance companies."Alas, nothing lasts forever and the FHA refund program ended with loans originated after December 8, 2004.
If you have a loan originated prior to December 8, 2004 you can see if you qualify for a refund WITHOUT any cost or charge by going to the FHA refund page. You’ll need your loan case number to use the system. This should be available on your closing papers from settlement, from the party that conducted closing and from your lender.
Where's The Premium Money?
During the period from fiscal 2001 through 2007 the FHA turned over more than $13.5 billion to the U.S. Treasury. Another $900 million or so went to the Treasury in fiscal 2008 and 2009. For fiscal 2010, says HUD Secretary Shaun Donovan, "we project that FHA will return to the tax payer over $1.7 billion."
The money generated by the FHA and given to the Treasury Department has a very important function, as I shall now explain.
FHA Reserves
The FHA is an insurance plan. Correctly-run insurance plans collect money over time, invest that money, and then have assets in hand when disasters strike.
In terms of real estate it's difficult to imagine a bigger disaster than we've seen during the past few years. Huge numbers of foreclosures have increased the supply of homes, pushing down prices. Rising unemployment levels have meant that many people cannot enter the marketplace as buyers while owners who are unemployed can suddenly face their loss of their homes. Worse, perhaps, are toxic loans -- option ARMs, interest-only mortgages and loans made with little or no documentation -- that are now failing in massive numbers.
The problem for the FHA is not that it's been imprudent, rather the problem is that when an FHA borrower is foreclosed the government must pay off the lender. If home prices were strong this would not be much of a problem because the property could simply be re-sold for a price at or near the loan amount. However, with property prices in many areas substantially reduced, the result is that remaining loan balances are often less than distressed sale prices. This means that in a growing number of cases the FHA is facing much larger claims than in the past.
In effect, the FHA program is being penalized by the loans it didn't make and the risks it didn't take. It's like being hit by a drunk driver when you're perfectly sober -- the accident is not your fault, but you suffer.
The FHA sets aside premium money to prepare for tough times. For instance, the size of the FHA capital reserves declined from 3 percent of the loan amount outstanding in 2008 to .53 percent in late 2009, according to HUD Secretary Shaun Donovan. This is below the required 2 percent capital reserve minimum.
However, the FHA also has the ability to get back the money it's given to the Treasury Department -- that $14 billion and more. The result is that the FHA program is better funded than scary headlines might suggest, especially when one considered the terrible real estate environment we're seeing.
So where does the FHA stand in terms of reserve money? As Forbes magazine has reported, "the FHA has a $45 billion cushion to cover $757 billion in home-loan guarantees."
Let's do some math: $45 billion equals 6 percent of $757 billion. That's three times the required minimum. (See: FHA: The Feds' Next Housing Debacle, March 15, 2010).
Why do you care about FHA reserves? One reason is that as reserves decline the FHA must take action to enlarge its capital base, most likely by increasing MIP premiums and raising qualification standards. This means you'll pay more for an FHA loan -- if you can get one. A second reason is that the FHA is self-funding; if its reserves were eaten away by losses the program will then have to be bailed out with taxpayer money.
FHA Foreclosures
The old expression is that a rising tide lifts all boats. It's equally true that with an ebbing tide all boats fall.
The mortgage meltdown has impacted all real estate. Even if you own property without any mortgage debt, the financial crisis still effects your property because a foreclosure across the street or down the road will reduce the sale value of your home, lower your equity and drive down your ability to finance and refinance the property.
The FHA is a victim of the mortgage crisis just like homeowners nationwide. The FHA did not reduce its lending standards, it did not insure toxic loan products, it did not permit loans that allowed prepayment penalties. Nevertheless, the FHA program has been impacted by the foreclosure mess if only because home values have fallen and unemployment levels have risen.
This brings us to several points:
First, more foreclosures mean more claims against the FHA insurance pool. This explains why reserve levels have fallen in the past two years. However, let's have some context: It's not just the FHA loan program which has seen higher loss levels, the same is true of private mortgage insurers and many lenders.
Second, the FHA has an excellent foreclosure avoidance record. According to the Mortgage Bankers Association, 13.57 percent of all FHA loans were delinquent during the fourth quarter of 2009 -- but the FHA foreclosure rate was just 3.57 percent -- not far behind conventional mortgages (3.31 percent).
What these figures mean is that the FHA has a very high "cure" rate. If you get into financial trouble and have an FHA loan, the FHA will try to help. There's no cost for such assistance. Just go to the FHA foreclosure avoidance page as soon as financial problems emerge or seem likely to emerge.
FHA Loan Limits
Historically the amount you could borrow with FHA financing was less than the amount available with a conventional loan. Under the old system if the conventional loan limit was $300,000 then the FHA loan limit for a single-family house in the continental US would be $261,000. Why? Because FHA mortgages were purposely restricted to 87 percent of the conventional loan limit.
At the end of 2008 the old restrictions ended and now there are at least three sets of FHA loan limits -- a basic or "floor" loan limit, a loan limit for “high cost” areas in the continental U.S. and a third loan limit for properties in Alaska, Hawaii, Guam and the Virgin Islands.
To make matters more complicated the FHA loan limit can differ even within a state. This happens because the limit is based on the county where you live.
For 2010 the FHA loan floor for owner-occupied properties look like this:
One-Unit —
$271,050
Two-Unit — $347,000
Three-Unit —
$419,400
Four-Unit — $521,250
For 2010, FHA loan limits in higher-cost areas are the same as the conventional loan limits in these regions and are as follows: