This article exposes the inclusion of default insurance premiums and impounds as part of the total monthly payment on an FHA-insured loan, and their effect on the amount the homebuyer is qualified to borrow. Similarly discussed are the costs of private mortgage insurance (PMI).

Considering the MIP

With the recent collapse of the real estate market after the Millennium Boom, conventional lenders severely reduced lending on California real estate. In an effort to fill the home loan void left by their departure and keep homeownership levels from plummeting, the Federal Housing Administration (FHA) stepped up to the plate to offer prospective homebuyers low-downpayment, low-credit score alternatives to conventional financing.

As a result, FHA-insured loans have had a revival of popularity in California, and are now used by nearly 40% of all homebuyers in the Golden State (a percentage that will soon drop substantially, but will not adversely affect and may likely assist in the ongoing stabilization of pricing in our real estate market).

This increased popularity of FHA-insured loans in California needs to be accompanied by loan payment transparency. Prospective homebuyers must not be misled, but instead advised of the true costs associated with these low-downpayment, FHA-insured loans: the built-in mortgage insurance premiums (MIP) and accompanying impounds.

Consider a prospective first-time homebuyer independently searching for properties online. He finds numerous qualifying properties that appear suitable — some single family residences (SFRs), some condominiums — around $235,000 in current value. He then takes a look at his mortgage pre-approval options. Among them are:

• a conventional loan requiring a 20% downpayment; or
• an FHA-insured loan requiring only a 3.5% downpayment.

Editor’s note — The FHA recently proposed increasing the downpayment requirement from 3.5% to 5% to reduce default rates. This proposal was defeated in the House of Representatives Financial Services Committee in late April of 2010.

The prospective homebuyer researches mortgage interest rates online and discovers the advertised interest rates for conventional mortgages and FHA-insured mortgages are very similar – around 5%. He does not want to put down a big downpayment, and based on these advertised rates, he decides to seek pre-approval for an FHA-insured loan.

Keeping in mind his desired property price of $235,000, a 3.5% downpayment would be $8,225. That leaves him with a principal loan balance of $226,775. Impounds for taxes and hazard insurance are estimated by lenders at around 1.5% of the total price of the property, approximately $283 monthly. He finds an amortization calculator and discovers his principal and interest payments at 5% interest will be roughly $1,217 monthly. The combined amounts of $1,500 are within the homebuyer’s budget.

The mortgage payment is more than principal and interest

Armed with this knowledge, the homebuyer hires a real estate agent to help him locate a suitable property. The homebuyer discusses his loan research with his agent. The agent informs the homebuyer that while lenders do advertise FHA loan rates which are close to those for conventional loans, the homebuyer who makes a downpayment of less than 20% is always charged an additional monthly rate for  default insurance, called mortgage insurance premium (MIP), to cover the FHA’s risk of a homeowner’s default. The current premium rates charged for MIP, the agent informs his homebuyer, include:

• 2.25% of the loan amount paid up-front at the time of closing, called the up-front MIP (UFMIP); and
• an additional annual MIP of 1.55% of the loan amount, paid monthly, in addition to the 5% interest on the loan. [HUD Mortgagee Letter 2010-02]

Editor’s note —  The lender who originates an FHA-insured loan following FHA underwriting guidelines takes on no risk of loss. The entire risk is placed on the FHA – our government — who steps in to take the lender’s loss position, having guaranteed the loan in the event of the homebuyer’s default. The MIP paid for by the homebuyer goes towards the FHA reserves used to pay for losses on loan defaults. The FHA coffers have recently and rapidly been depleted by the unprecedented popularity of low-downpayment, FHA-insured loans — and their ensuing high rate of defaults. [For more information on FHA-insured loans, current students can access first tuesday’s Real Estate Finance, Chapter 39: “The FHA-insured home loan,” from within your Student Hompage in the “Library” tab. Log in with your Department of Real Estate (DRE) license number under “Enrolled Student Services.”]

In response to these losses, the House of Representatives recently passed a bill which would decrease the UFMIP rate and increase the annual MIP rate from the current .55% to 1.55%. While the bill is still pending passage in the Senate, first tuesday includes the higher annual MIP in this scenario since the bill will almost certainly pass if the Senate is to protect the FHA’s solvency and avoid another Treasury bailout. [HUD Mortgagee Letter 2008-22 ; for more information on the effect of this pending increase in FHA-insured MIP rates, see the June 2010 first tuesday article, FHA Reform Act Passed in the House of Representatives.]

Thus, the homebuyer’s 3.5% downpayment after factoring in the up-front 2.25% MIP, plus approximately another 2% on the price for escrow and other loan origination costs, is actually a cost of acquisition of 7.75% of the price of the property using an FHA-insured, purchase-assist loan. [See below for a specific discussion of the UFMIP and information on arranging for the seller to pay the 2.25% MIP, 2% loan fees and more.]

The 5% annual interest rate quoted by the lender is effectively 6.55% (5% interest rate + the 1.55% MIP rate). This combined rate is paid on the loan balance until the property’s loan-to-value (LTV) ratio is equal to or less than 78%, and then only if the homebuyer has been paying the MIP for at least five years. [HUD Mortgagee Handbook 4155.2 Chapter 7.3.c]

By doing a quick calculation, the buyer’s agent determines the MIP would cost the borrower $292.72 each month, which becomes part of the total monthly payment collected by the lender. FHA-insured loan guidelines set a maximum total monthly payment equal to a housing debt-to-income (DTI) ratio of 31% of the homebuyer’s gross monthly income. This 31% maximum housing payment includes:

• principal and interest;
• impounds for property taxes and hazard insurance, collectively known as TIs;
• MIP;
• homeowners’ association (HOA) fees;
• ground rent;
• special property assessments; and
• payments for any acceptable secondary financing. [HUD Mortgagee Handbook 4155.1 Chapter 4.F.2.b.]

The cost of not having a 20% down payment

Thus, by putting down less than 20% on the purchase of the home, the homeowner dramatically reduces the amount he can borrow to pay for a property.  The increased MIP payment, impounds, etc. he must make every month are considered part of his housing payment, and the payment is limited to a maximum of 31% of his income. If the homebuyer decides to purchase a condominium or an SFR in a planned unit development (PUD), that further reduces his borrowing power as HOA fees are also included as part of his 31% maximum DTI ratio (HOA fees generally represent another 1% of the property’s price).

After considering the information provided to him by his agent, the homebuyer then visits a representative with a local lender and obtains a pre-approval letter for an FHA-insured loan. He now understands his reduced borrowing ability when choosing an FHA-insured loan as pointed out in the pre-approval letter by the lender’s representative.

Later, the buyer’s agent goes over the pre-approval letter with the homebuyer to double-check the lender for omission of mortgage insurance premiums, impounds for TIs, HOA dues, and any other applicable fees which must be considered to determine the approved loan amount. This not only helps ensure his buyer will not have the unpleasant surprise of applying for a loan and finding out he does not qualify for the amount quoted in the pre-approval letter, but also keeps the buyer’s agent from expending time and energy negotiating a deal that cannot close if the loan amount is erroneously calculated.

The up-front MIP lump sum charge

In January of 2010, the FHA increased the UFMIP charge from 1.75% to 2.25% of the loan amount in an effort to offset their insurance fund losses caused by the rising default rate on FHA-insured loans. [HUD Mortgagee Letter 2010-02]

Although previously exempt from the UFMIP, FHA condominium loans are now also subject to the existing UFMIP rate. [HUD Mortgagee Letter 2008-22]

The UFMIP may be:

• entirely financed by adding it to the mortgage. If added, the total mortgage amount may exceed existing LTV limits by the amount of the UFMIP [HUD Mortgagee Handbook 4155.1 Chapter 4.F.2.b.]; or
• paid in cash at closing.

The buyer’s agent, when preparing his buyer’s purchase agreement, needs to consider negotiating with the seller to arrange for the seller to pay this premium by shifting the payment of the buyer’s non-recurring closing costs to the seller. The FHA currently allows sellers to pay up to 6% of the buyer’s closing costs on an FHA-insured loan. [See first tuesday Form 152 §7]

Editor’s note — In January 2010, the FHA proposed reducing the allowable seller concessions from 6% of the loan amount to 3%. The proposed effective date was stated as “early summer,” however no official effective date has been set. The delay is perhaps due to the pending change in MIP arrangements currently being discussed in the Senate. Similar to those changes, the reduction of allowable seller concessions is most likely a foregone conclusion — part of a larger FHA scheme to force the buyer to put “more skin in the game” to lessen his likelihood of simply walking away or defaulting on it.

If the buyer’s agent does not structure negotiations to have the seller pay the UFMIP and other FHA up-front loan costs, the homebuyer will end up investing another 2.25% of the price plus loan points and closing costs of another 2% in the property and have only a 3.5% equity to show for it (part of these costs are subsidized through income taxes).

This is a shaky start for any homebuyer, especially should the asset value of the property not increase at least at the current rate of consumer inflation. This property value increase allows the initial 96.5% LTV ratio for the mortgage to more quickly get to below the 94% break-even point at which the homebuyer begins to build up net equity through the amortization of principal, should he need to sell. Only by an increase in property value can the homebuyer recover his invested capital upon a resale of the property.

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Copyright © 2010 by first tuesday Realty Publications, Inc. Readers are encouraged to reprint or distribute this information with credit given to the first tuesday Journal Online — P.O. Box 20069, Riverside, CA 92516.