The venerable FHA loan has been an important path to home ownership for moderate-income buyers since 1934, when it came into being as part of the National Housing Act. Since that time, some 35 million families have used the federally insured mortgage program to become homeowners with very small down payments.
FHA became even more prominent in the recent crisis, as loans for borrowers with lower credit scores disappeared overnight. As the country lurched out of the Great Recession, FHA found that their insurance pool to cover foreclosure losses was drying up. They decided that increasing the insurance premiums would be the best way to replenish it and preserve the program.
FHA’s mortgage insurance premiums have been marching higher for several years. At present, there is an initial premium of 1.75% added to the “base” loan amount, plus 1.35% paid monthly. For a $300,000 purchase, this amounts to $5,066 initially, and $331 paid monthly. Although it was once possible to eliminate the insurance after about 10 years, FHA mortgage insurance is now permanent. The only way to remove it is to refinance into a conventional loan.
Even though interest rates for FHA loans are lower than for conventional mortgages, they are still a very costly option for most homeowners. A buyer with a credit score of 720 will get a conventional mortgage at a rate of around 4.5% (no points). With a down payment of 5%, that borrower can expect a monthly mortgage insurance premium of $270 (.69%)—and the lender will allow the insurance to be canceled once the loan reaches 80% of the home’s value. If the property appreciated at 4% per year, the buyer would be able to drop the mortgage insurance in less than three years.
The FHA loan would have a slightly lower interest rate—3.75% with no discount points—but the buyer would add the $5,066 initial premium to the loan, in addition to paying a monthly premium of $331. The buyer with a conventional loan will pay only slightly more initially:
Even though the conventional payment is $107.00 higher, the buyer will be able to drop the mortgage insurance within two or three years, depending on appreciation. Once that happens, the difference is significant: while the FHA buyer will be saddled with costly mortgage insurance for as long as he has the loan, the conventional buyer’s payment will drop to $1,444—$252 lower than for FHA.
An FHA loan is useful in certain cases. There are adjustments to the rate for lower FICO scores, so a buyer whose credit scores show some battle scars may still be better off with the government insured program. There may also be those who are struggling just to save the 3.5% down payment. For those hopeful buyers, the additional 1.5% in down payment could be a major hurdle.
Still, every buyer entering the market should be aware of the real cost difference between FHA and conventional loans. Saving up the additional 1.5% down payment could be a good investment.