The FHA loan program has been in existence since 1934. It provides government support for low to moderate-income borrowers to buy homes, offering small down payments (currently 3.5%), low interest rates and flexible underwriting standards.
These attractive features come with a price, however. The higher risk associated with the small down payment makes mortgage insurance a necessity. The borrower pays the premiums in two ways. The up-front premium, 1.75% of the base loan amount, is added to the loan. Thus, a buyer paying 3.5% down for a $300,000 home will have a $294,566 loan amount—98.2% of the purchase price.
FHA also charges a monthly renewal of 1.35%. This would amount to $325/mo for the $300,000 purchase. According to Northpoint Mortgage Lenders, this is more expensive than the private mortgage insurance (PMI) charged on low down payment conventional loans. Conventional PMI for a 95% loan would cost between $128 and $273, depending of credit score. Moreover, the FHA insurance will be in place over the life of the loan. Lenders will cancel PMI once the loan to value ratio drops to 78%, based on the market value of the property.
There is another, rather sneaky cost to FHA loans. When the borrower pays off an FHA loan, whether by refinancing or by selling, the FHA lender charges interest after the payoff, to the end of the month. If you are paying off a $260,000 FHA loan with a 4.5% rate, you’ll pay a full month’s interest even if you pay the loan off on the first day of the month. That interest would amount to around $975. Conventional lenders charge interest on a per diem basis—a significant absence of rip-off.
There’s some good news on the horizon for FHA borrowers. HUD has just issued a new directive stating that these “post-payoff” charges are no longer allowed; as of January 21, 2015, lenders will charge only for the days the borrower has the money. Paying off that $260,000 loan on the second of the month will involve $65.00 in interest—not $975.
This will ultimately save consumers millions of dollars—and that is quite a “minor” improvement.
CORRECTION: My good friend, Doug Adamczyk, pointed out to me that the way I wrote this, it appears that the post-close interest goes away after January 21. The new rule takes effect for loans funded after that date; so if you pay off your your year-old FHA loan next March, you’ll still want to close escrow as close to the end of the month as possible.
Thanks for the heads-up, Doug!
By the way, this new rule came into being as a result of the Consumer Financial Protection Bureau’s rule limiting prepayment penalties.