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Will changing mortgage insurance fix FHA?

FHA vs Conventional dilemmaFHA loans are about to get a little less unattractive (yes, I know that’s a double negative. I did it on purpose).

Since 1934, millions of people have become homeowners because of the Federal Housing Administration’s (FHA) loan programs. The combination of low down payment requirements (presently 3.5%) and flexible underwriting standards has made FHA a very attractive program to many.

FHA insures these low down payment loans by collecting mortgage insurance, paid in an up-front premium added to the loan balance, plus a monthly premium. This money goes into a fund to pay claims to lenders as required.

Since the housing crisis, however, with its epidemic of foreclosures, the insurance fund has shrunk to dangerous levels. FHA’s response has been to increase cost of its mortgage insurance; at present, the initial premium is 1.75% of the base loan amount, added to the loan. The monthly premium is 1.35%. This means that buying a home for $300,000 would require a cash down payment of $10,500 (3.5%) and an up-front MI premium of $5,066. The total loan amount would be $294,500.

Interest rates for FHA are lower than for conventional loans; today’s rate for an FHA loan would be 3.375%, while an equivalent conventional loan would likely carry a rate of 3.75%.

A conventional loan would require mortgage insurance, as well. Depending on the buyer’s credit score, the monthly premium would be between $270 and $370 per month for the conventional loan. FHA’s premium would be $331. The payment for that $300,000 home would be $2,060 with an FHA loan, $2,044 for a 97% conventional.

Yesterday, Julian Castro, the secretary of the Department of Housing and Urban Development, announced that FHA would cut its monthly MI premium by .5%, to .85%. This will reduce the monthly payment on a $300,000 home to $1,940—a drop of $120 a month.

While this will enable FHA to regain some of the market share it has lost to conventional loans, it doesn’t address the real problem: the mortgage insurance stays in place for the life of the loan. The only way to get rid of it is to refinance and pay it off. By contrast, a borrower can eliminate private mortgage insurance (PMI) once equity reaches 20%. Assuming a modest 4% appreciation rate, that will take about three years. Then, the conventional mortgage will be quite a lot cheaper than the FHA version: $1,775 per month instead of $1,940—$163 less each month.

There are some other variables, like credit scores, that can make an FHA loan a reasonable choice. Any buyer should do a careful comparison of all possible scenarios before committing to either one.

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