Who Should Take an FHA Mortgage?

April 24, 2000, Revised October 31, 2002, March 14, 2003, September 7, 2004 "We recently purchased a home with 20% down, with mortgage insurance provided by the Federal Housing Administration (FHA). When we closed on it, we were told that the new federal law effective July 29, 1999 that established the ground rules for canceling mortgage insurance did not apply to FHA loans. Is that true?" Yes, but why in the world did you take out an FHA-insured loan when you were able to make a 20% down payment? "We were inexperienced first-time buyers, so we went with the lender recommended by the builder. The loan officer advised us that FHA is secure because it is a government loan." The loan officer probably took advantage of you. I can't say for sure because I don't have all the loan details, but the loan officer's reason for selecting an FHA loan makes no sense. FHA loans are for borrowers who seek loans no larger than the loan size limits set by the program, and either can't meet a 3% down payment requirement, have poor credit, or both. Most FHA borrowers make down payments of less than 3 percent. FHA allows you to buy a home with 1% down. Private mortgage insurers require 5 percent down on most loans, and only allow 3 percent down on special programs.  FHA is also liberal in allowing gifts to be used for paying settlement costs. (See Are Seller Contributions Kosher?). FHA borrowers also usually have weaker credit than private insurers accept. FHA allows higher ratios of expense to income, is more tolerant of existing debt, and will allow the income of co-borrowers who don't live in the house to count fully in measuring income adequacy. It is also quite forgiving about bad credit. For example, a borrower need be out of a Chapter 7 bankruptcy for only 2 years, and out of a Chapter 13 bankruptcy for only 1 year. But there is a third group of FHA borrowers that shouldn't exist. It is comprised of borrowers like you who would meet the requirements of a conventional loan but are steered to an FHA. They pay more for their loan than they should. FHA loans are generally available in the market at about the same interest rate and points as conventional loans with the same term. There may be a difference in mortgage insurance premiums, however.  On an FHA 30-year fixed-rate mortgage (FRM), the mortgage insurance premium is 1.5% of the loan amount paid up front plus .5% of the loan balance paid monthly. The premium is the same regardless of the down payment. On conventional loans, the insurance premium depends on the down payment. With 5% down, the premium on a 30-year FRM is about the same as on an FHA. With 10% or more down, the premium on conventional loans is lower.  Borrowers who can put 10% down and have good credit will usually do better with a conventional loan. Recently, an additional option has opened for borrowers who are unable to make a down payment but have strong credit. The interest rate is higher on these zero-down-loans, but you don't have to pay for mortgage insurance. I recently compared the best deal I could find on the internet on an FHA 30-year FRM with the comparable zero-down loan offered on-line by Countrywide Funding, one of the major lenders offering such programs. The FHA loan was at 8% and zero points while Countrywide's loan was 8.375% and 1.25 points. When you factor in the FHA mortgage insurance premium, the cost of the FHA was higher. Assuming no other charges on either loan, the "all-in" cost of the FHA over 30-years was 8.75% compared to 8.51% on the Countrywide loan. Over 5 years, the difference is even greater, 9.07% compared to 8.69%. Cash-poor borrowers with good credit should explore this new option. September 7, 2004 Postscript: Although it does not apply to the case described above, John Ragano of Virginia Commerce Bank pointed out a situation where an an FHA loan may be advantageous to a borrower who can make a substantial down payment. If a borrower has credit good enough for FHA but not for conventional financing except at sub-prime terms, the FHA will be better if the borrower can improve his credit over the first year or two of the loan and then refinances. FHA loans do not carry prepayment penalties, which most sub-prime loans do, and most of the mortgage insurance premium will be refunded. Copyright Jack Guttentag 2004

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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