There are two primary types of mortgage loans available in today’s mortgage marketplace, VA, USDA, and FHA all fall into the government-backed category. Conventional loans are a little different due to the fact that the bank assumes the risk on a loan with no government backing. Government-backed loans will compensate the lender for all or part of a loss the lender experiences in the case of a defaulted VA, USDA or FHA loan.
When a conventional loan goes into foreclosure, the lender must sell the property with the hopes of recovering enough from the sale to cover the outstanding loan balance and associated fees. So where does this guarantee come from? With the FHA loan, the guarantee comes in the form of mortgage insurance or “MIP”
When an FHA loan goes into default, the lender is compensated for the loss. This compensation is financed by two separate forms of mortgage insurance found on every FHA loan. The FHA program requires just a 3.5% down payment, which is why many first-time buyers like the program. Lenders also like the FHA loan because of the low down payment requirement but also because the loan comes with a guarantee. As long as the lender approved the loan application using proper FHA protocol the guarantee will apply and the lender gets its money back.
There are two types of mortgage insurance associated with an FHA loan- an upfront premium that is rolled into the loan amount and an annual premium paid in monthly installments. Currently, the upfront premium is 1.75% of the loan amount and added to the initial loan. For example, a home is purchased for $250,000. The buyers select an FHA loan and will put down 3.5% of $250,000, or $8,750 for a loan amount of $241,250. The upfront MIP premium of 1.75% comes to $4,221 and when added to the initial loan amount the total is rounded to $245,450.
Next, the annual MIP premium is calculated, currently at 0.85% of the loan amount. In this instance, 0.85% of $245,450 is $2,086 per year paid in monthly installments of $173. Each year as the loan balance draws down, the monthly premium is recalculated and lowered as well.
The examples above indicate a normal 30-year fix term with 3.5% down payment. Homebuyers putting down greater down payment may see lower premiums. Read more about FHA mortgage fees here.
Both premiums are indeed a form of insurance and treated as such. The borrowers make the premium payments to the benefit of the lender. This is the guarantee to the lender. Some have incorrectly misinterpreted the government-backed guarantee to mean the borrowers are guaranteed a loan approval yet the guarantee applies to the mortgage company. Buyers must still qualify for an FHA loan based upon standard underwriting guidelines such as minimum credit scores, stable employment with a two-year history and sufficient funds to close on the transaction. Sufficient funds include the down payment amount, associated closing costs, and any cash reserve requirements.
If the borrowers qualify based upon the credit, income, and assets and are looking for a mortgage loan requiring as little cash as possible, you’ve probably got an FHA loan in your future. Please contact us today at ph: 800-743-7556 with questions.