Topic 13.5: Government Insured FHA Program

Learning Objective

After successfully completing this topic, you will be able to describe the characteristics of FHA mortgages and common FHA loan programs.

Purpose of the Federal Housing Administration (FHA)

The FHA mortgage loan program was established by the National Housing Act of 1934. Its main purposes were to
• promote improved housing standards,
• help to stabilize the mortgage market, and
• insure mortgages.

The FHA is part of the Department of Housing and Urban Development (HUD). FHA is one of the few federal agencies that is completely self-funded. Today, the FHA insures nearly 25 percent of all new mortgages.

Characteristics of FHA Mortgage Loans 

Loan insurance

FHA acts as a government insurance agency, assisting consumers who can’t make large down payments on houses. With lower down payments, many more buyers can buy homes. To reduce the risk to lenders from the low-down payments, the FHA uses the Mutual Mortgage Insurance fund (MMI). Each borrower pays an up-front fee to purchase the insurance and pays a monthly payment. If a lender forecloses, the mortgage insurance pays the lender for any losses. The program is a win-win. Consumers can buy homes; builders sell more homes; and mortgage lenders make more loans. The FHA successfully increased the number of homeowners.

Lending source

FHA does not make mortgage loans. FHA loans are made by lenders who have been approved by the FHA. FHA does not insure investor loans; borrowers must be owner-occupants.

Discount points

FHA lenders may charge discount points which may be paid by either the borrower or the seller. Discount points are an additional source of funds to the lender which increases the lender’s yield.

Down payment

The FHA calls the down payment the “minimum cash investment.” The minimum down payment for borrowers with a credit score of at least 580 is 3.5% of the purchase price or the appraisal amount, whichever is less. Some lenders require scores as high as 620. The reason that some lenders are more conservative is that FHA will penalize lenders with fines or suspension if they have default rates that are too high. If a borrower’s credit score is 500 or above but lower than the lender’s minimum, the borrower must make a 10% down payment.

The down payment can be satisfied with the borrower’s own cash, getting a gift from a family member or an employer. The gift cannot come from the seller, builder, or real estate licensee. Closing costs cannot be counted as part of the down payment.

Loan limit

FHA has established maximum loan amounts (regionally) which it will insure. If the down payment, called the initial investment, results in a loan amount higher than FHA maximum loan, the borrower must make up the difference in cash.

Mortgage Insurance Premium (MIP)

Borrowers must pay two types of mortgage insurance.

Up-Front Mortgage Insurance Premium (UFMIP) 

The premium paid by the borrower when the loan is originated is called an up-front mortgage insurance premium. The charge is 1.75% of the base loan amount. It can be financed and made part of the loan amount.

Monthly Mortgage Insurance Premium (MMIP)

Borrowers also are required to pay a monthly mortgage insurance premium. The amount of the fee depends on the amortization term and the amount of the borrower’s down payment. The MIP payments are included as an expense when the lender prepares the borrower’s loan qualifying ratios.

Qualifying for an FHA Mortgage Loan

Qualifying ratios

There are two ratios used by lenders who make FHA mortgage loans, the housing expense ratio (HER) and the total obligations ratio (TOR).

Housing expense ratio

FHA mortgages allow borrowers to use up to 31 percent of their monthly gross income to pay for their monthly housing expenses, including principal, interest, taxes, insurance, MIP payments, and  any required homeowner association fees. To calculate the housing expense ratio, divide the borrower’s monthly housing expense by the borrower’s monthly gross income.

Example of the housing expense ratio A family has gross monthly income of $7,500. Their payments of  principal, interest, taxes, insurance, and homeowner’s association payments are $2,145. What is their housing expense ratio? Solution: The housing expense ratio is 28.6 percent ($2,145 ÷ $7,500). The family will qualify for the loan based on the housing expense ratio, but they will also have to qualify for the total obligations ratio.

Total obligations ratio

A borrower can pay a maximum of 43 percent of the monthly gross income for the housing expenses and other debts. The formula for calculating the total obligations ratio is: total month debt payments ÷ monthly gross income.

Example of the total obligations ratio A family has gross monthly income of $7,500. Their payments of  principal, interest, taxes, insurance, and homeowner’s association payments are $2,145. Their other debts are $940. What is their total obligations ratio? Solution: The total obligations ratio is 41.13 percent ($2,145 + 940 ÷ $7,500). The family will qualify for the loan based on the total obligations ratio.

Interest rate

Lenders set the interest rates on FHA mortgages based on market rates. The FHA does not set interest rates for mortgages.

Appraisal

Buyers who want to finance the purchase of a home with an FHA mortgage must pay for an FHA appraisal ordered by the lender. FHA appraisals have stricter requirements because of HUD-created minimum property standards. These standards include safety, security, and soundness. This makes the appraisal cost about $50 more than other types of appraisals, but gives the homebuyer a little more protection. Necessary repairs identified on the appraisal must be completed before the transaction closes.

FHA appraisers will note
• lead paint (danger to children and pregnant mothers),
• earth-to-wood contact (termites),
• railings on decks, porches, and balconies (for safety),
• windows (must be intact),
• roof (no leaks), and
• water supply (must be safe and adequate).

The FHA appraisal is not a substitute for a home inspection. The FHA strongly urges home buyers to order a home inspection.

Closing costs

While sellers or real estate licensees cannot give the borrower a gift for the down payment, they can pay closing costs of up to six percent of the purchase price. Sometimes sellers inflate the selling price in order to be able to pay the closing costs. That’s fine if the property  appraises for the higher price.

Loan Assumption Criteria

FHA mortgages are assumable; conventional loans, with a few exceptions, are not. The FHA requires that buyers be financially qualified to assume the loan and be approved by the FHA. After the FHA approves the buyer, the buyer assumes all the obligations and the seller is relieved of liability. This feature may make the resale of a home with an FHA loan much more valuable if interest rates are higher at the time of sale.

Example Assume that a borrower financed her home purchase with an FHA loan of $200,000 at 4.5% interest eight years ago. The payment for principal and interest is $1,013. When the property is listed for sale while interest rates are 7%, an assumption at the 4.5% rate is very attractive. (The principal and interest payment on a 7% interest rate is $1,331).

Prepayment

FHA loans can be paid off early without any type of penalty.

Common FHA Loan Programs

Section 203(b), homeownership, fixed rate

The FHA 203(b) is the most common mortgage loan insured by the FHA. If the home needs less than $5,000 in repairs, this mortgage program will work.

Section 203(k), homeownership, fixed rate

FHA 203(k) mortgages are often called rehabilitation mortgages because they are intended for homes needing significant rehab. The FHA appraiser will prepare a post-rehab appraisal in addition to an as-is appraisal.

The mortgage is disbursed in stages called draws, including the first draw to purchase the house, then additional distributions are made as repairs are completed.

Section 234(c), Condominium units 

The FHA Section 234(c) program insures a 30-year loan for the purchase of a unit in a condominium building. The building must have at least four dwelling units. Down payments and qualifying requirements are like the 203(b) program.

Section 251, adjustable rate mortgage

Section 251 adjustable rate mortgages keep the initial mortgage interest rates and payments low. They may change over the life of the loan. The maximum fluctuation in the interest rate in any given year cannot be more than 1%. The loan interest rate may not ever adjust higher than 5% more than the initial rate. This is more attractive than conventional adjustable mortgage loans which can change 2% annually and 6% over the life of the loan.

The FHA adjustable rate mortgage is like the 203(b) loan with 3.5% down payments.