Shouldn’t FHA Mortgages Be Cheaper?

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FHA mortgages should cost less. This is a government program that churns out billions of dollars in annual surpluses, money that comes from borrowers. If FHA mortgage loans were less costly then more people – especially first-time buyers – could buy homes. That would be great for buyers and also sellers, lenders, and brokers. It might save borrowers thousands of dollars over the life of the loan.

Let me explain.

The FHA is an insurance plan. It charges premiums like any insurance program. Those premiums are set aside in a reserve fund to assure that lenders get paid if a borrower defaults on a loan. Because the FHA backs individual mortgages — and because lenders know that the FHA will pay their claims in the event of foreclosure – qualified borrowers can obtain financing with just 3.5% down.

Where the Money Goes

Congress says the FHA must maintain a 2% capital ratio. That means the cash in the reserve fund must equal 2% of all the claims the FHA might face if there are lots of foreclosures. Keep your eye on the 2% figure.

In fiscal year 2019 – the period that ended September 30th – the FHA had a surplus. A HUGE surplus. It’s cash reserves increased by $8.7 billion. Its capital ratio reached 4.84%, more than twice as much as the 2% Congress demands.

If the FHA was a private company shareholders would cheer. They would want bigger dividends. But the FHA is not a private company. It’s part of the federal government. It exists to benefit taxpayers. If it’s doing so well doesn’t that mean premiums are too high?

FHA Mortgage Premiums

Suppose you need a $250,000 mortgage. The interest rate is 4% fixed over 30 years. Your costs look like this:

Under the FHA program there’s an upfront mortgage insurance premium (the upfront MIP) equal to 1.75% of the mortgage amount. In this example that’s $4,375. However, under FHA rules you don’t have to pay the upfront MIP. It can be added to the mortgage balance. The actual mortgage amount is now $254,375.

At 4% interest over 30 years the monthly cost for principal and interest is $1,214.42.

In addition to the monthly payment for principal and interest there is also a second type of FHA insurance cost, the .85% annual mortgage insurance premium (the annual MIP) charged on the base mortgage amount, $250,000 in this example. It amounts to $177.08 per month in the first year.

The monthly payment is now $1,391.51.

You can see that FHA insurance costs are a big chunk of the monthly payment. That’s a problem because when FHA lenders look at loan applications they check the debt-to-income ratio – the DTI. If monthly debt payments are too high borrowers may not get financing.

The Debt-to-Income Problem

It turns out that even tiny changes in mortgage costs can impact a lot of people. Back in September mortgage rates rose by .07% in a week. They increased to 3.56%. That’s a very low rate by historical standards. Even so, many people felt the pain of such a small increase. According to Black Knight, the “refinanceable” population – the number of high-quality refinance candidates with 20% down and credit scores of at least 720 – fell by 1.9 million potential borrowers. In addition, large numbers of marginal borrowers are also impacted by even small mortgage cost changes.

HUD itself has had problems dealing with FHA borrower debt. The FHA program likes borrowers with DTIs below 43%. However, in fiscal year 2018 nearly 25% of all FHA borrowers were above 50%. The situation is so bad that in March the government posted new FHA rules to cut down on high-DTI borrowers.

How HUD Can Cut FHA Insurance Costs

HUD has good reasons to cut FHA insurance rates.

First, FHA reserves are more than double congressional requirements.

Second, a reduction in monthly loan costs will result in lower DTI levels and less risk for the FHA program.

Third, the FHA mortgage program is a major source of funding for first-time borrowers. Almost 83% of the purchase mortgage insured by FHA in FY2019 went to first-time buyers. Additional FHA borrowers will be able to buy homes if insurance costs are lower. As we saw with the Black Knight figures, even small changes in mortgage costs can greatly enlarge – or shrink – the pool of qualified borrowers. In turn, more real estate demand means stronger home prices, something sellers very much favor.

How can FHA insurance premiums be cut? There are several options.

HUD can cut the upfront MIP from 1.75% to something lower. While this seems attractive the financial result will be small. That’s because most FHA borrowers elect to finance the upfront MIP so the cost is only reflected in a minor increase in the monthly mortgage payment.

A better option is to reduce the annual mortgage insurance premium. In 2008, for example, it was set at .50% rather than the .85% seen by most FHA borrowers today. The difference for a $250,000 mortgage would be a reduction in the annual MIP from $177.08 a month to $104.17 monthly. That’s a difference of $72.91 per month, enough to realistically help many borrowers who are near or over debt-to-income limits.

Not only is an FHA insurance premium sensible, it may be more likely than we think. While some in Washington want to keep the capital ratio where it is or aim even higher, this is an election year. What better way to please lots of people nationwide then to cut FHA mortgage costs? Millions of people would be impacted – including a lot who vote.

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About Peter G. Miller

Peter G. Miller is a nationally-syndicated real estate columnist who appears in dozens of newspapers as well as the author of seven books published originally by Harper & Row.